Skip to main content
Internet Archive's 25th Anniversary Logo

Full text of "HIGH FREQUENCY TRADING'S IMPACT ON THE ECONOMY"

See other formats


AUTHENTICATED , 
US. GOVERNMENT 
INFORMATION ^ 


S. Hrg. 113-477 

HIGH FREQUENCY TRADING’S IMPACT ON THE 

ECONOMY 


HEARING 

BEFORE THE 

SUBCOMMITTEE ON 

SECURITIES, INSURANCE, AND IN\^STMENT 

OF THE 

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 
UNITED STATES SENATE 

ONE HUNDRED THIRTEENTH CONGRESS 
SECOND SESSION 
ON 

EXAMINING THE VALUE, BENEFITS, RISKS, BURDENS, AND CONCERNS 
HIGH FREQUENCY TRADING CREATES FOR THE ECONOMY AND THE 
MARKETPLACE 


JUNE 18, 2014 


Printed for the use of the Committee on Banking, Housing, and Urban Affairs 



Available at: http://www.fdsys.gov/ 


U.S. GOVERNMENT PRINTING OFFICE 
91-299 PDF WASHINGTON : 2014 


For sale by the Superintendent of Documents, U.S. Government Printing Office 
Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC area (202) 512-1800 
Fax: (202) 512-2104 Mail: Stop IDCC, Washington, DC 20402-0001 


COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 


TIM JOHNSON, 
JACK REED, Rhode Island 
CHARLES E. SCHUMER, New York 
ROBERT MENENDEZ, New Jersey 
SHERROD BROWN, Ohio 
JON TESTER, Montana 
MARK R. WARNER, Virginia 
JEFF MERKLEY, Oregon 
KAY HAGAN, North Carolina 
JOE MANCHIN III, West Virginia 
ELIZABETH WARREN, Massachusetts 
HEIDI HEITKAMP, North Dakota 


South Dakota, Chairman 
MIKE CRAPO, Idaho 
RICHARD C. SHELBY, Alabama 
BOB CORKER, Tennessee 
DAVID VITTER, Louisiana 
MIKE JOHANNS, Nebraska 
PATRICK J. TOOMEY, Pennsylvania 
MARK KIRK, Illinois 
JERRY MORAN, Kansas 
TOM COBURN, Oklahoma 
DEAN HELLER, Nevada 


Charles Yi, Staff Director 
Gregg Richard, Republican Staff Director 

Dawn Ratliff, Chief Clerk 
Taylor Reed, Hearing Clerk 
Shelvin Simmons, IT Director 
Jim Crowell, Editor 


Subcommittee on Securities, Insurance, and Investment 


MARK R. WARNER, Virginia, Chairman 
MIKE JOHANNS, Nebraska, Ranking Republican Member 


JACK REED, Rhode Island 
CHARLES E. SCHUMER, New York 
ROBERT MENENDEZ, New Jersey 
JON TESTER, Montana 
KAY HAGAN, North Carolina 
ELIZABETH WARREN, Massachusetts 
HEIDI HEITKAMP, North Dakota 


BOB CORKER, Tennessee 
RICHARD C. SHELBY, Alabama 
DAVID VITTER, Louisiana 
PATRICK J. TOOMEY, Pennsylvania 
MARK KIRK, Illinois 
TOM COBURN, Oklahoma 


Milan Dalal, Subcommittee Staff Director 
Bryan Blom, Republican Subcommittee Staff Directorr 


(II) 



CONTENTS 


WEDNESDAY, JUNE 18, 2014 

Page 

Opening statement of Chairman Warner 1 

Opening statements, comments, or prepared statements of: 

Senator Johanns 3 

WITNESSES 

Hal S. Scott, Nomura Professor and Director, Program on International Fi- 
nancial Systems, Harvard Law School 6 

Prepared statement 30 

Jeffrey M. Solomon, Chief Executive Officer, Cowen and Company, LLC, 

and Cochair, Equity Capital Formation Task Force 7 

Prepared statement 36 

Andrew M. Brooks, Vice President and Head of U.S. Equity Trading, T. 

Rowe Price Associates, Inc 9 

Prepared statement 69 

Additional Material Supplied for the Record 

Illustrations of miniflash crashes from May 13, 2014, submitted by Chairman 

Warner 72 

Statement submitted by Greg Mills, Head of Global Equities Division, RBC 
Capital Markets 75 


(HI) 




HIGH FREQUENCY TRADING’S IMPACT ON 
THE ECONOMY 


WEDNESDAY, JUNE 18, 2014 

U.S. Senate, 

Subcommittee on Securities, Insurance, and 

Investment, 

Committee on Banking, Housing, and Urban Affairs, 

Washington, DC. 

The Subcommittee met at 10:01 a.m., in room 538, Dirksen Sen- 
ate Office Building, Hon. Mark R. Warner, Chairman of the Sub- 
committee, presiding. 

OPENING STATEMENT OF CHAIRMAN MARK R. WARNER 

Chairman Warner. This hearing will come to order. 

I want to thank Senator Johanns’ staff for working with our of- 
fice today in putting together today’s hearings. I want to thank our 
witnesses, who I will come to introduce in a couple of moments. 

I do feel, as I was mentioning a little bit yesterday, this is not 
the first hearing or even the first hearing this week on this subject. 
We perhaps were front-run a little bit yesterday by Senator Levin’s 
activities, but we think we can build upon his good work as the 
Senate takes a look at this very important issue. 

Yesterday, Senator Levin’s hearing really focused on potential 
conflicts of interest between brokers and investors. Our hope will 
be that this hearing will take a larger, macro view of the effects 
of high frequency trading on the economy and the marketplace. 

Over the past few decades, we have seen remarkable techno- 
logical progress and innovation in our securities markets coupled 
with substantial regulatory reform. Now, some of these advances 
and reforms, including decimalization, have brought considerable 
rewards for individual investors by narrowing spreads and increas- 
ing liquidity. Most trades today can happen within fractions of a 
second, providing good prices and counterparties for those seeking 
to buy equities around the world. 

But, at the same time, we have seen increased volatility and 
periodic dislocation. I think we all remember the flash crash a 
while back, but perhaps what did not get as much attention is that 
this — that was not the only incident. Just last month, on May 13, 
we had a series of mini flash crashes in a series of individual 
stocks. Such events do little to engender confidence and, indeed, 
may hinder investment in the stock market, adversely affecting the 
broader economy, particularly as it affects small cap stocks. 

Gains in liquidity, I know, for most folks on the street are seen 
as the holy grail, but we have to ask ourselves at some point, at 

( 1 ) 



2 


what price this increased liquidity, and does sometimes simply 
progress and technological innovation hear other costs that need to 
be examined? 

Some critics of current U.S. market structure place the blame on 
high frequency trading. For purposes of today’s hearing, we are 
going to define high frequency trading to include computerized al- 
gorithmic trading of a number of varieties to essentially address 
when a computer is making a decision based on a program as op- 
posed to a human. 

In recent months, I know there has been a lot of renewed atten- 
tion on this subject given to the publication of Michael Lewis’s 
book. Flash Boys. And, I know many of my colleagues and I have 
growing concerns with what is happening in our markets that is 
leading to this erosion of confidence. 

There are a few reforms that I would like to see the SEC imple- 
ment to help strengthen confidence in the economy. First, and I 
think Senator Johanns will speak to this, as well, conducting a tick 
size pilot. As a former venture capitalist, I have concerns over 
front-running that impairs the ability of small companies to find 
adequate liquidity for their shares in the marketplace. This activity 
can adversely affect underwriting decisions or even the choice to go 
public, which obviously harms capital formation in its beginning. 

Chairman White recently announced that the Commission is try- 
ing to finalize details of a potential pilot. I believe it should be for 
an adequate length of time, preferably more than a year, to capture 
enough data. It should also cover all of the trading venues, lit and 
dark, to ensure collection of accurate data. 

Second, the SEC must expedite the implementation of a consoli- 
dated audit trail. Way back in May of 2010, a day after the infa- 
mous flash crash, then-Senator Ted Kaufman took to the floor. He 
talked about that challenge, and he and I both went to then-Sen- 
ator Chris Dodd, who was Chair of this Committee, to require the 
SEC to report to Congress on the need for a consolidated audit 
trail, better order screening, and the risk posed by high frequency 
trading. 

Unfortunately, more than 4 years later, we have seen little 
progress on our request, especially on the issue of the consolidated 
audit trail. The SEC has issued two extensions to the SROs and 
FINRA, delaying a proposal until September 30 of this year at the 
earliest. However, having this in place will help regulators decipher 
what is happening in the market, so we need to implement this 
ASAP, and I hope the SEC is listening. 

Chairman White recently posed some reforms to enhance trans- 
parency in the market, and I thank her for moving on that, and 
it is clear that the SEC and the CFDC have a monumental task 
in policing our markets and they need full funding. I will continue 
to advocate for that as long as I am in this position. 

Again, I look forward to hearing from our witnesses. I am going 
to move to Senator Johanns for his statement, and then, with the 
willingness of my colleagues, go ahead and introduce the panel and 
get to the testimony. 

Senator Johanns. 



3 


STATEMENT OF SENATOR MIKE JOHANNS 

Senator Johanns. Mr. Chairman, let me start out and say to the 
witnesses, thanks for being here. We appreciate it. I look forward 
to this hearing. 

I also want to thank the Chairman for holding this hearing on 
high frequency trading. No doubt about it, it is getting attention 
these days, if not a lot of noise. 

One thing that I probably need to be reminded about, as I think 
about my last months in the U.S. Senate, is if I have the capacity 
to write a book and get on “60 Minutes”, I will probably get a lot 
of Congressional attention and I will be back here, sitting where 
you are sitting. 

[Laughter.] 

Senator Johanns. Maybe I can even convince Mr. Lewis to write 
a book about the need for housing finance reform or the overreach 
of EPA regulations. Both of those need attention. 

Now, the spotlight is shining brighter. We all acknowledge that. 
The issue of high frequency trading, though, is not a new concept. 

So, as I said, I look forward to the witnesses talking about the 
impact of high frequency trading on our economy, asking and an- 
swering questions, does the practice help or does it hurt investors? 

Now, it does seem to me that retail investors really have never 
had it better. Costs are low. There seems to be ample competition. 
Market access is very easy these days. I definitely do not think the 
markets are rigged, as some have suggested. 

However, I also believe that we cannot simply ignore certain 
market structure issues. We should always be encouraging liquid- 
ity. After all, why have a market if liquidity is not a part of it? We 
should be encouraging fairness. We should be encouraging trans- 
parency in the marketplace. We need to ensure that the U.S. re- 
mains the envy of the world when it comes to capital markets. I 
would just put out there, I do not think anyone does it better. 

I also want to associate myself with comments made by Chair- 
man Mary Jo White, who I have a lot of confidence in. She re- 
cently, in a public speech, said this, and I am quoting, “We should 
not roll back the technology clock or prohibit algorithmic trading, 
but should assess the extent to which computer-driven trading may 
be working against investors rather than for them.” There is a lot 
said in that quote. 

America has always encouraged innovation. We want fastest. We 
want strongest. We want most powerful. I can relate to this. Grow- 
ing up on a dairy farm in Northern Iowa in the 1950s and then 
becoming Secretary of Agriculture, I have seen a lot of change in 
that arena. The equipment and technology now is so much faster. 
It is so much smarter. The combines are so far advanced over what 
we were doing. It is unbelievable, what has happened in that 
arena. Who benefits from that? The consumer benefits from that, 
because they have a supply of food that is just unparalleled in the 
world and pay less of their disposable income. Technology is a good 
thing. Our financial trading systems have, obviously, gone through 
a remarkable, if not similar, evolution. 

I think everyone here today is concerned with investor con- 
fidence. So, from the witnesses today, I would like to hear how 



4 


small investors and small companies are affected in today’s trading 
world. How do they fare? 

As I said earlier, it seems that technology developments over the 
last several years have benefited retail investors by making the eq- 
uity markets more accessible and affordable for the moms and the 
pops in Nebraska. But, investors are also, understandably, con- 
cerned when news stories suggest that the deck is somehow 
stacked, that the stock market has become an insider’s game, that 
it cannot be trusted. So, I hope that we can talk about these real 
or perceived problems today. 

Also, I am concerned with investor confidence in the small cap 
company space. The goal for every stock is liquidity. Can you mar- 
ket that stock? While the market seems to work fine for a large, 
if not blue chip, stock, the smaller public companies have not fared 
as well. 

I know there has been discussion about widening tick sizes for 
smaller emerging growth companies. There was legislation on the 
House side that directs the SEC to issue a pilot program to test 
whether wider trading increments will promote more active trading 
and boost liquidity for smaller companies. Interestingly enough, 
this House bill passed 412 to four. I do believe that is part of what 
spurred the SEC to act. A House vote of 412 to four on a complex 
piece of legislation is almost unheard of, a remarkable result. 

So, I would like to get the panel’s thoughts on the pilot program 
and also hear about any other special market structure reform 
ideas that will benefit the small investor, the Main Street compa- 
nies, those folks who are trying to find their place in this market. 

Mr. Chairman, a great hearing today. I compliment you for call- 
ing it. Some very, very important issues that can have significant 
economic consequences to our States and to our country. Thank you 
very much. 

Chairman Warner. Thank you. Senator Johanns. 

We have been joined by Senator Reed, who was longtime Chair 
of this Subcommittee, and Senator Warren, who brings, obviously, 
a wealth of knowledge to this subject. And, with their discretion, 
I am going to go ahead and introduce the witnesses and we can get 
started. 

First, Mr. Hal Scott is the Nomura Professor at Harvard Law 
School, where he has taught since 1975, and Director ofthe Com- 
mittee on Capital Markets Regulation. Professor Scott teaches 
courses on capital market regulation, international finance and se- 
curities regulation. He is currently Director of hazard and a mem- 
ber of the Bretton Woods Committee and a past Governor of the 
American Stock Exchange. It is my understanding, as well, is he 
taught Senator Reed 

Senator Reed. He did, without any effect. 

[Laughter.] 

Chairman Warner. and has worked with, obviously, a col- 

league of Senator Warren’s. When I was there, I did not have a 
chance to take one of his courses, but I look forward to his testi- 
mony. 

Mr. Jeffrey Solomon is Chief Executive Officer of Cowen and 
Company and a Director of the Cowen Group. Mr. Solomon is re- 
sponsible for overseeing all of Cowen and Company’s business, in- 



5 


eluding investment banking, capital market sales, and trading and 
research. Mr. Solomon is also amember of the Committee on Cap- 
ital Markets Regulation as well as the Cochair of the Equity Cap- 
ital Formation Task Force, a group of professionals from across 
America’s start-up and small cap company ecosystems. Thank you 
and welcome, Mr. Solomon. 

And, Mr. Andrew Brooks is Vice President of T. Rowe Price, 
where he is head of U.S. Equity Trading. He joined the firm in 
1980 as an equity trader and assumed his current role in 1992. Mr. 
Brooks is currently a member of the Investment Company Institute 
Equity Markets Advisory Committee — that is a mouthful — and is 
on the board of the National Organization of Investment Profes- 
sionals. Welcome, Mr. Brooks. 

So, we will get to the testimony. Professor Scott. 

STATEMENT OF HAL S. SCOTT, NOMURA PROFESSOR AND DI- 
RECTOR, PROGRAM ON INTERNATIONAL FINANCIAL SYS- 
TEMS, HARVARD LAW SCHOOL 

Mr. Scott. Thank you. Chairman Warner, Ranking Member 
Johanns, and Members of the Subcommittee, for permitting me to 
testify before you today on the impact of high frequency trading on 
investor confidence and capital formation in U.S. equity markets. 
I am testifying in my own capacity and do not purport to represent 
the view of any organizations with which I am affiliated. 

High frequency trading, or HFT, is a topic that has generated 
significant attention in recent years, intensifying more recently 
with the publication of Michael Lewis’s book. Flash Boys. It is my 
intention to provide a thoughtful response to a debate that has 
sometimes been fraught with frenzied emotion. 

Let me be clear at the outset. The emergence of high frequency 
trading activity in and of itself has not negatively affected our sec- 
ondary markets. Our secondary markets remain strong, with 
roughly 50 percent of global exchange trading occurring on tl.S. ex- 
changes. With roughly half of this volume generated by HFT firms, 
the increased liquidity provided by HFTs lead to decreased costs of 
stock issuance, thus improving capital formation. And, of course, 
improved capital formation for our businesses leads to higher 
growth in the real economy. 

Transaction costs for retail and institutional investors have also 
been in continual decline over the past 10 years, as evidenced by 
current bid-ask spreads, and have fallen by 50 percent since 2006 
and brokerage commissions that are at historic lows. Retail inves- 
tors can now trade for less than $10 a trade. 

Since many retail investors access the equity markets indirectly 
through institutional funds or advisors, like mutual funds, institu- 
tional costs are highly relevant to retail investors, as well. Leading 
financial economists find that the average transaction costs for in- 
stitutional orders are also at an all-time low. 

Investor confidence in our markets also remains strong. Since the 
2010 Flash Crash, there has been a net inflow of more than $50 
billion in holdings of U.S. -listed companies and a total net inflow 
of nearly $500 billion in all exchange-traded products. Clearly, in- 
vestors are not fleeing from our equity markets due to perceived 
threats of high frequency trading. 



6 


Moreover, experts have found that high frequency trading has 
not caused an increase in stock market volatility, although I think 
we will go around a little bit on that. And, the SEC has also largely 
addressed future Flash Crash concerns by implementing single 
stock circuit breakers and revising marketwide circuit breakers 
that will temporarily halt trading if price movements become too 
volatile. 

Critics of HFT have questioned the fairness of allowing certain 
traders to benefit from their physical proximity to an exchange, 
known as colocation, and have access to faster data feeds. However, 
the SEC requires exchanges to offer such access to all market par- 
ticipants at the same cost, and remember, a large number of retail 
investors trade through these institutions who have such access. 
Over 90 percent of market participants have access to such serv- 
ices, including retail investors indirectly. 

Thus, it is hard to argue that the U.S. equity market is broken 
as a result of the emergence of high frequency trading. Nonethe- 
less, there is always room for targeted improvement of the current 
regulatory structure, and I would now like to present a few specific 
proposals. 

First, regulators should consider mandating and harmonizing ex- 
change-level so-called kill switched. A kill switch is a mechanism 
that would halt a particular firm’s trading activity when a 
preestablished exposure threshold has been breached, thus stop- 
ping erroneous orders and preventing any further uncontrolled ac- 
cumulation of positions. This would act against a single firm. 

Second, they might consider addressing the volume of order mes- 
sage traffic generally, which can create market instability, by es- 
tablishing order-to-trade ratios, and regulators should consider 
charging fees for extreme message traffic in particular cir- 
cumstances. 

Third, regulators should consider abolishing immunity that ex- 
changes have from liabilities for losses from market disruptions 
based on their SRO status, which might better align the exchanges’ 
incentives to limit potentially risky trading that could pose wide- 
spread operational risk. 

And, I also endorse the idea, and I think it is quite important, 
of a much better audit trail, the CAT effort that the SEC is under- 
way with, and I agree with Senator Warner that they should act 
sooner rather than later on that, because knowing what happens 
is the key to all of our understanding, and that audit trail will help 
give us knowledge that we currently do not have about how trading 
is actually being conducted. 

In concluding my remarks, I wish to reiterate that the strength 
of U.S. equity markets has positively affected capital formation, 
and by extension, promoted job creation. Any changes in HFT regu- 
lation should be based on a factually careful assessment of abuses 
and regulation to fix them without harming the overall perform- 
ance of our markets. 

Thank you, and I look forward to your questions. 

Chairman Warner. Thank you. Professor Scott. 

Mr. Solomon. 



7 


STATEMENT OF JEFFREY M. SOLOMON, CHIEF EXECUTIVE OF- 
FICER, COWEN AND COMPANY, LLC, AND COCHAIR, EQUITY 

CAPITAL FORMATION TASK FORCE 

Mr. Solomon. Good morning, Chairman Warner, Ranking Mem- 
ber Johanns, and the Members of the Subcommittee. Thank you for 
inviting me to speak today regarding high frequency trading’s im- 
pact on the economy. 

My name is Jeffrey Solomon and I am the Chief Executive Offi- 
cer at Cowen and Company, an emerging growth investment bank 
focused on servicing growth-oriented companies in key sectors of 
our economy. Along with Scott Cooper, the Chief Operating Officer 
of Andreessen Horowitz, I am also the Cochair of the Equity Cap- 
ital Formation Task Force. And, interestingly, I have spent most of 
my career as an institutional investor in equities, so I understand 
this issue from many sides. 

Over the past year, there has been significant debate about the 
economic impact of HFT, high frequency trading, on the equity cap- 
ital markets in the United States and how the rise in their trading 
activity has introduced increased market risk and volatility. We 
would argue that the debate surrounding HFT is actually sympto- 
matic of a more complex market structure that encourages poten- 
tially counterproductive trading behavior, behavior that limits true 
market depth and trading volume in many stocks and hinders in- 
vestors’ ability to buy and sell those stocks in small cap companies, 
in particular. 

This has resulted in reduced availability of capital for small pub- 
lic companies to expand their businesses and create valuable pri- 
vate sector jobs. As such, any debate about the pros and cons of 
HFT really needs to address the structure of the equity market 
that has given rise to its existence. 

The rise in electronic trading and the regulations that followed 
resulted in new market structure for equities that was intended to 
benefit investors, and today, our market’s structure is marked by 
speed of execution, lower transaction costs, and sub-penny incre- 
ments, a dynamic which works well enough in highly liquid large 
cap stocks, but fosters opacity and liquidity in small cap stocks. For 
investors in small cap stocks, true price discovery is far more im- 
portant than speed of execution. 

As a result, it has become more costly and difficult for institu- 
tional investors, who are the primary providers of growth capital 
to emerging companies, to invest, trade, and make markets in 
small caps. Companies with market caps of $750 million and below 
represent only 2 percent of the daily trading volume in the United 
States, and, on average, are only 30 percent held by institutions. 
Without meaningful institutional ownership, capital formation for 
small companies has declined to levels well below historic levels 
and has impeded price appreciation for many individual investors, 
as well. 

While the JOBS Act had made it easier for emerging growth 
companies to go public — the number of IPOs has increased since its 
passage — little has been done to improve the quality of secondary 
market trading in small stocks. And, to address these concerns, the 
Equity Capital Formation Task Force presented its findings and 



8 


recommendations to the United States Treasury in a report which 
sets out two areas for consideration. 

One is to encourage increased liquidity in small cap stocks by 
fostering a simpler, more orderly market structure for small cap 
stocks, and to expand capital for small cap and micro cap compa- 
nies by completing regulatory changes outlined in the JOBS Act in 
accordance with Reg A Plus. These recommendations are designed 
to enhance capital formation for small companies while balancing 
the needs of investor protection and preserving many of the impor- 
tant improvements made to market structure that investors have 
enjoyed since the advent of decimalization. 

In order to improve market structure, we have recommended 
that the SEC implement a well designed pilot program that allows 
for a true empirical test on the effects of both wider spreads and 
limited trading increments in small caps, which we believe will en- 
courage fundamental buyers and sellers to meaningfully engage 
with each other. By designing a pilot that requires all market par- 
ticipants to cluster their bids and offers at fewer discrete incre- 
ments, and by limiting the ability of certain market participants to, 
quote-unquote, “price improve” in sub-penny increments, we will be 
able to observe whether or not the volume and depth necessary to 
enhance liquidity in small caps will improve. Improved trading li- 
quidity begets cheaper and more efficient access to capital for these 
companies, and improved access to capital translates into increased 
job creation in the private sector. 

One of the most important aspects of designing a successful pilot 
program is ensuring that such a pilot program is allowed to operate 
for a long enough period for time to gather meaningful data around 
whether or not the changes to the market structure are having de- 
sired effects. We strongly believe that market participants, espe- 
cially those that use algorithms and trade frequently, will need 
time to adjust their trading practices and/or business models in 
order to adopt to the new market structure. However, just as they 
adopted to decimalization and other market structure changes over 
the past 15 years, we are confident that they will adapt to these 
proposed market changes in the small cap market, as well. 

It appears as if the SEC, under the leadership of Chairwoman 
White, has made a strong commitment to enhancing overall liquid- 
ity of the capital markets in general and for small companies, more 
importantly. The Task Force supports the data-driven results ori- 
ented approach that the Commission has espoused publicly over 
the last 9 months. Our members continue to advocate that a one- 
size-fits-all market structure does not meet the needs of any mar- 
ket participants. 

We praise Congress on the passage of the JOBS Act, which dem- 
onstrated that a well-drafted legislation and regulation can meet 
the dual needs of fostering increased formation for capital while 
maintaining investor protection. Now is the time to create momen- 
tum, or to capitalize on the momentum created by the JOBS Act 
to take additional steps to further the growth of America’s most 
promising private and public growth companies. We owe it to those 
Americans seeking jobs and those companies creating those jobs to 
try and adjust a small part of the market structure in order to im- 
prove access to capital. 



9 


I thank you for this time and I welcome your questions and dia- 
logue. 

Chairman Warner. Thank you, Mr. Solomon. 

Mr. Brooks. 

STATEMENT OF ANDREW M. BROOKS, VICE PRESIDENT AND 

HEAD OF U.S. EQUITY TRADING, T. ROWE PRICE ASSOCI- 
ATES, INC. 

Mr. Brooks. Good morning. Chairman Warner, Ranking Member 
Johanns, and distinguished Members of the Senate Subcommittee 
on Securities, Insurance, and Investment, thank you for the oppor- 
tunity to testify today on behalf of T. Rowe Price regarding the im- 
pact of high frequency trading on the economy. 

My name is Andy Brooks. I am a Vice President and Head of 
U.S. Equity Trading at T. Rowe Price. This is my 34th year on the 
trading desk at T. Rowe Price. T. Rowe Price was founded in 1937 
and is a Baltimore-based advisor, serving more than 10 million in- 
dividual and institutional investor accounts. 

Since I last testified before this Committee in September of 2012, 
we have seen considerable turnover in Congress, this Committee, 
and at the U.S. Securities and Exchange Commission. However, 
there has been little change in addressing the issues discussed 21 
months ago, although we do applaud the SEC’s efforts in imple- 
menting limit up, limit down controls and developing the consoli- 
dated audit trail. Additionally, we are encouraged by Chair Mary 
Jo White’s recent comments suggesting a heightened focus on im- 
proving market structure. And, we appreciate this Committee’s 
continued interest in improving our markets. 

However, order routing practices, payment for order flow, maker/ 
taker pricing, market data arbitrage, and the myopic quest for 
speed are all issues that remain unaddressed. In addition, we have 
grown increasingly concerned about the growth of dark pools and 
the challenges of the direct fast feed operating alongside the slow 
security information processor feed. 

Although this hearing is focused on HET, we believe HET is 
merely symptomatic of larger market structure problems. We are 
cautious not to lump all electronic trading into the class of HET, 
and, further, we do not believe that all HET is detrimental to the 
market. We are supportive of genuine market making. However, 
we acknowledge there are predatory strategies in the marketplace 
that have been enabled by our overly complex and fragmented 
trading markets. Those parties utilizing such strategies are exploit- 
ing market structure issues to their benefit and to the overall mar- 
ket’s and individual investors’ detriment. 

We question whether the functional roles of an exchange and a 
broker-dealer have become blurred over the years, creating inher- 
ent conflicts of interest that may warrant regulatory action. It 
seems clear that since the exchanges have migrated to for-profit 
models, a conflict has arisen between the pursuit of volume and re- 
sulting revenue and the obligation to assure an orderly market- 
place for all investors. The fact that 11 exchanges and over 50 dark 
pools operate on a given day seems to create a model that is sus- 
ceptible to manipulative practices. 



10 


If a market participant’s sole function is to interposition them- 
selves between buyers and sellers, we question the value of such 
a role and believe it puts an unneeded strain on the system. It begs 
the question as to whether investors were better served when the 
exchanges functioned more akin to a public utility. Should ex- 
changes with de minimis market share enjoy the regulatory protec- 
tion that is offered by their status as exchanges or should they be 
ignored? 

Additionally, innovations in technology and competition, includ- 
ing HFT, have increased market complexity and fragmentation and 
have diluted an investor’s ability to gauge best execution. For ex- 
ample, in the race to increase market share, exchanges in alter- 
native trading venues continue to offer various order types to com- 
pete for investor order flow. Many of these types facilitate strate- 
gies that can benefit certain market participants at the expense of 
long-term investors, and while seemingly appropriate, often, such 
order types are used in connection with predatory trading strate- 
gies. We are supportive of incremental efforts, such as recent initia- 
tives by the New York Stock Exchange to eliminate 12 order types 
from their offerings. 

We also believe that increased intraday volatility over the past 
year is just symptomatic of an overly complex market. Though com- 
mission rates and spreads have been reduced, volatility continues 
to be alarmingly high. It was refreshing to see a recent report from 
RBC Capital Markets examining the impact of intraday volatility 
and exposing the high cost to investors. Most academics only look 
at close to close market volatility. 

Increased market complexity results in a lack of investor con- 
fidence. A recent Gallup Poll noted that American household own- 
ership of stocks continues to trend well below historic norms. One 
can never be sure what drives investor behavior, but it seems clear 
to us that we need to do a better job of earning investors’ con- 
fidence in our markets. Those investors who have stayed on the 
sidelines in recent years, for whatever reason, have missed out on 
significant equity returns. We worry that the erosion of investor 
confidence can undermine our capital markets, which are so impor- 
tant to the economy, job growth, and global competitiveness. 

Over the past two decades, the markets have benefited from in- 
novations in technology and competition. Generally, markets open 
at 9:30, they close at 4, and trades settle efficiently and seamlessly. 

Vibrant and robust markets function best when there are varied 
investment opinions, styles, and approaches. However, given the 
myriad of ways to engage in the markets, we feel that investors 
would benefit from an increased focus on market structure, particu- 
larly features that enable predatory and manipulative practices. 
Disruptive HFT strategies are akin to a tax loophole that has been 
exploited and needs to be closed. Market participants utilizing such 
strategies are essentially making a riskless bet on the market, like 
a gambler who places a bet on a race that has already been won 
and for which he knows the outcome. 

In the spirit of advancing the interests of all investors, we might 
make the following suggestions. We envision a pilot program where 
all payments for order flow, maker/taker fees, and other induce- 
ments for order flow routing are eliminated. We also envision a 



11 


pilot that incorporates wider minimum spreads and some version 
of a “trade at” rule, which we believe would lead to genuine price 
improvement. These programs should include a spectrum of stocks 
across market caps, average trading volumes, among other factors. 

Additionally, we would advocate for a pilot program that would 
mandate minimum trade sizes for dark pools. Dark pools were 
originally constructed to encourage larger trading interests, and it 
seems perverse that many venues on the lit markets, or exchanges, 
have a larger average trade size than dark pools. 

HFT and market structure issues were recently brought into the 
public spotlight by Michael Lewis and his book. Flash Boys. Some- 
times, it takes a storyteller like Mr. Lewis to bring attention need- 
ed to an issue, and we hope that all parties involved will come to- 
gether and seize this opportunity to improve our markets. Again, 
we would advocate for pilot programs to test and ultimately imple- 
ment measured, yet significant, changes. 

On behalf of T. Rowe Price, our clients, and shareholders, I want 
to thank the Committee for this opportunity to share our views on 
how we can together make our markets as good as they can be. 

Chairman Warner. Thank you, gentlemen. Very good testimony. 

I am going to ask you to put 5 minutes on the clock for each of 
us. I will try to be brief I would ask you to be fairly brief in your 
responses, so I am going to try to get as many questions as I can 
in my time. 

I have a particular bias, as a former venture capitalist, on the 
notion of small cap stocks, and would point out to my colleagues 
that data by the Kauffman Foundation has pointed out that lit- 
erally, I think, 80 percent of all net new jobs that have been cre- 
ated in the last 30 years in America have come from startup enter- 
prises. So, how we accelerate that is, I think, a policy focus that 
we would all share. 

Professor Scott and Mr. Brooks, do you share Mr. Solomon’s be- 
lief that there should be some level of differentiation between small 
cap and larger caps and pilots like the tick size pilot moving for- 
ward? Other suggestions? Professor Scott. 

Mr. Scott. Well, I am a member of Jeffs Task Force and I do 
agree with 

Chairman Warner. Press your microphone button. 

Mr. Scott. I am a member of Jeffs Task Force and endorse the 
recommendations for a pilot study on increasing the tick size for 
small caps. I think the result will be to show that with more trad- 
ing and more liquidity, you know, we will encourage small caps. 
But, I think it is important to do a pilot study. There is a lot of 
controversy around this question as to whether increasing the tick 
size will really increase trading and we need to find out. So, I am 
certainly in favor of the pilot program. 

Chairman Warner. Do you believe that the basic premise that 
HFTs potentially could disadvantage small cap stocks at this point? 
Do you think — I guess, obviously, you are on that Committee, but 
I took that as 

Mr. Scott. I am not sure I see a connection between HFT per 
se and disadvantaging small caps. I think what we need to do is 
increase the tick size and see what results, even with high fre- 
quency traders as they might adjust to trading in such an environ- 



12 


ment. Maybe they will trade less, OK, with a bigger tick differen- 
tial. But, that will be their adjustment to an increased tick size. 

Chairman Warner. Mr. Brooks, and then we will let Mr. Sol- 
omon have a 

Mr. Brooks. Senator, my sense is that this pilot program is way 
overdue. We have been talking about it for a long time. I think 
there is vigorous debate about whether — what will happen as an 
outcome, and I think it is time to try. You know, we are very inter- 
ested in increasing displayed liquidity, especially in small cap 
stocks, and I think a larger tick size, the cost — the barrier to entry 
for someone who is trying to interposition themselves there will 
grow and perhaps they will be discouraged from playing in that 
sandbox. Greater displayed liquidity, I think, would be good for in- 
vestors and would attract, perhaps, more interest, investor interest 
in those names. 

You know, at the heart of the issue is trying to figure out a 
mechanism to allow someone to tell the story of small companies, 
to promote small stocks, promote in a good way, to tell the story 
about the growth and the potential. We have removed so many in- 
centives for brokers and others, financial advisors, to tell the story 
of a stock that it has made it hard for people to figure out why they 
should care about small companies. 

Mr. Solomon. Listen, we have written extensively about it and 
I totally agree. I think one thing, to augment what Professor Scott 
said, is it is not just wider spreads. It is wider spreads and limited 
trading increments, and this is really important. There are a lot of 
small cap stocks that trade at wider than a penny. What we have 
talked about here is having a minimum bid and offer. 

So, when a stock trades wide and all of a sudden there is interest 
or displayed liquidity, all of a sudden, it rushes to a penny, and 
that precludes institutional investors like Andy, who make up a 
significant portion of the net worth of American households in- 
vested in stocks. They cannot get access to the small companies 
that exhibit the best growth, because by the time he shows up to 
buy a meaningful stake, it is reduced to a penny and they are just 
waiting for him to sit there and indicate size so they can pick him 
off. 

And, so, what we have said is, if you forced people to cluster at 
bids and offers, fewer of them, at five-cent increments, there are 
only 20 places where you can cluster in between each dollar. And, 
you limit the trading at the bid, at the offer, or one price in the 
middle. That should be ample for any fundamental buyer and seller 
to do price discovery and it limits this game or casino type behavior 
we have seen with sub-penny price improvement. 

Chairman Warner. Let me get one last question in, and I am 
going to take as a quick nod, yes, that we ought to move forward 
and keep the pressure on the SEC to move on their consolidated 
audit trail efforts. 

Mr. Solomon. Yes. 

Mr. Brooks. Yes. 

Chairman Warner. Let me try to get Mr. Solomon and Professor 
Scott’s comments. Mr. Brooks has got a fairly aggressive outline of 
reforms, including, for example, the pilot of getting rid of some of 
the, what appears to be inherent conflicts on the maker/taker cir- 



13 


cumstances that we all discussed. You have got some general 
agreement. Would each of you go as far as Mr. Brooks has gone, 
Professor Scott and then Mr. Solomon. 

Mr. Solomon. Go ahead. You are up. 

Mr. Scott. He wants to defer to me. I am not — I do not think 
so. I am not ready for pilot studies yet on these issues. I think the 
first step is that we should get the SEC study done and see what 
they come up with on these issues, and we should hope that they 
act expeditiously. I might say in their defense that they have had 
a lot on their plate for the last several years and they have gotten 
around a market structure now and I think they are going full bore 
on it. So, I think we need to get a lot more information about the 
problems, focus in on what the abuses are. 

I also think we have to be careful about pilot studies. While I en- 
dorse Jeffs pilot study, we can confuse the market a lot with a lot 
of pilot studies going on at the same time, where different stocks 
trade in different ways. And, so, we have to be very careful, it 
seems to me, about — and, then, when you design a pilot study, you 
have to have a control. So, some people are not going to be trading 
under the pilot. Other people will. We do not know exactly how the 
SEC will devise their pilot, but if you do not have that, then you 
do not have a controlled experiment. So, it — and it all depends on 
how you design this pilot, OK. 

So, I am not ready for pilots on this issue. I think on tick size, 
we have had a lot of discussion over several years. A lot of work 
has been done on it. SEC has studied it intensively, and I think 
we are ready for a pilot. I do not think we are ready for pilots on 
these other issues. 

Mr. Solomon. So, I think we designed our proposals here to en- 
gage in — within the context of the existing maker/taker regime. So, 
we have said that this only is 2 percent of the daily average trad- 
ing volume, so the people that are making a fair amount of money 
trading large volumes should not be impacted by a small cap stock 
because it is not a significant portion of their revenue. 

On the issue of maker/taker, it is not — if you were setting up a 
market structure from scratch, I think we can acknowledge that it 
is not the most ideal economic way to incent behavior. But, it is 
what it is, in part because we got here through regulation. And, if 
we are going to undo maker/taker, we had better have a pretty 
good idea of how we are going to incent buyers and sellers to meet 
and how that is going to occur before we pull that plug or we will 
see a material drop in liquidity, simply because people will have to 
adjust their business models. 

Chairman Warner. I would simply say, I concur with Professor 
Scott, the SEC has got a lot on their plate, one of the reasons why 
I support full funding, but we also have to see the kind of — we 
need to see the action from them. 

Senator Johanns. 

Senator Johanns. Thank you, Mr. Chairman. 

Every one of you presented fascinating testimony, interesting tes- 
timony, and I think it raised so many complicated issues. So, let 
me, if I might, take a step back here and ask you about your pref- 
erence in terms of how we approach this, because if we just spent 
the next hour writing down the significant issues, I will bet you we 



14 


could not get it done in that hour. And, I am trying to figure out 
process-wise what is the best approach here, because the one thing 
we do not want to do is mess up a system that has done some aw- 
fully good things. Now, there may be some issues, and I do not 
want to necessarily debate that. 

Process-wise — Professor, I will start with you — would it be your 
preference that we look to the Chairman of the SEC, the SEC 
itself, to start working through these issues, identify approaches, 
and use its regulatory powers to deal with these issues, or would 
you rather have Congress try to — you know how we are functioning 
these days — would you rather have Congress grab a hold of this 
issue and see what we can do here? And, we have broad shoulders. 
You can tell us what you think and we will not be offended, I prom- 
ise you. 

Mr. Scott. Senator, I have dealt with a lot of complexity in my 
life. This is one of the most complex areas you will ever encounter. 
When you go through particular questions of this trade or that 
trade and who is getting an advantage and how it works, it is very 
complicated. 

Senator Johanns. Yes. 

Mr. Scott. And, I think that says caution to legislation before 
we have the experts, OK, do their best job to formulate what the 
problems are and what the solutions are. And, I think your role for 
the time being is to make sure that the SEC goes forward on this. 
And, by the way, I am one that thinks the SEC should be ade- 
quately funded to do these kinds of jobs. I think it is totally unfair 
to the SEC to put a lot on their plate and not give them the money 
to do it. 

Senator Johanns. OK. 

Mr. Scott. So, I think, you know, let us have the SEC do it. You 
keep the pressure on for them to do it and you review their find- 
ings. 

Senator Johanns. Mr. Solomon. 

Mr. Solomon. I think it is a very complex issue, but I think 
there is actually a relatively few number of changes you can make, 
and I think, well within an hour, you could have it laid out. It is 
actually pretty straightforward if you start with some basic 
premise, which is simpler — simpler markets. Simpler markets fos- 
ter better behavior from fundamental buyers and sellers. We have 
just got a market structure that basically has gotten away from, do 
you want to own this at this price? Do you want to sell this at this 
price? And 

Senator Johanns. But, let me ask you about that. You talked 
about sub-penny price improvement. Tell me, just as straight- 
forward as you can, does Mr. Brooks win with that? 

Mr. Solomon. No. 

Senator Johanns. Who is the winner and who is the loser when 
you do that? 

Mr. Solomon. So, sub-penny price improvement is what enables 
electronic market makers to aggregate retail order flow and give 
them the execution inside the national best bid and offer. So, if the 
regime requires you to give a retail order or individual order an 
execution at the best bid and offer when it hits the floor, or when 



15 


it actually gets displayed, the best way to ensure you do that is to 
crawl inside whatever bid and offer there is by a tenth of a penny. 

Andy and his compatriots on the institutional side do not benefit 
from that because they are not individual orders. So, his ability to 
get an — he can stand there at the bid, and sit or stand there on 
the offer, and a lot of shares can trade at the bid and the offer and 
he does not get a fill. That is a problem, because a lot of folks, or 
a lot of other intermediaries are aggregating positions or selling po- 
sitions in the hopes of being able to sell to him at a price higher 
or buy it from him at a price lower 

Senator Johanns. And 

Mr. Solomon. and that is what is happening with sub — that 

is where sub-pennying becomes a very difficult market issue. 

Senator Johanns. Right. As an individual investor, then, do I 
benefit? 

Mr. Solomon. So, you benefit in a couple of ways. So, you cer- 
tainly benefit by having five-dollar commissions. This is the maker/ 
taker regime is what underpins cheap execution. 

Senator Johanns. Yes. 

Mr. Solomon. We question whether or not you actually benefit, 
because if you buy individual — most individuals are owning stocks 
that are in the growth range. We have seen what the disparity is 
in terms of individual ownership. Seventy percent — if you go to 
sub-$250 million companies, it is, like, 85 percent owned by indi- 
viduals. The only reason to own those stocks is because you think 
they are going to go higher and because — and, what makes them 
go higher? Institutional involvement. So, there is — now, the market 
is biased against getting people like Andy involved in small cap 
stocks. So, while you may have gotten a five-dollar execution, did 
you — and, you may have actually given up the opportunity for price 
improvement. 

Senator Johanns. But, I may want the five-dollar execution. 

Mr. Solomon. Mm-hmm. 

Senator Johanns. You know, I remember the good old days when 
this did not exist and I had a few stocks and I called a broker and 
they charged me an arm and a leg and said, “I will settle up with 
you in 7 days,” and I am kind of going, wait a second. I think I 
lost on that deal. 

Mr. Solomon. So, there is a middle ground. 

Senator Johanns. And, the fact that you are telling me, “But, 
Mike, your stock might have gone up,” is not very reassuring to 
me. I want a five-dollar trade. What is wrong with that? 

Mr. Solomon. There is nothing wrong with wanting five-dollar 
trades, and we think there is enough competition in the market- 
place that people will compete on commission. Listen, we should 
not be competing on commissions as a way to drive revenues. We 
should be competing on investment ideas. So, go to your broker 
that gives you — that shows you over a period of time that they can 
consistently make you money. Then commission dollars actually do 
not matter that much, and we — but we should not have 

Senator Johanns. What if I am a rugged individualist, and quite 
honestly, I do not want to deal with a broker. 

Mr. Solomon. OK. 



16 


Senator Johanns. I want to go someplace. I want to pay my five 
dollars for a trade. I want to give — I want to get access to all of 
the information they can give me. I want to dig into it. I want to 
study it. And, I am not alone. And, I am using me as a hypothetical 
here because I do not buy and sell or trade. I do not trade stocks. 
But, having said that, millions of Americans have warmed up to 
this idea and they like it. 

Mr. Solomon. Which is fine. There will still be people that offer 
cheap execution because we have got a lot of benefits. So, I think 
it is fine. There will still be cheap execution. 

What is missing in this, though, is a little bit of balance, because 
Andy manages a bunch of money in your 401(k) or in your pension, 
I mean, all these other areas, all these other ways that you access 
the market, and he is being precluded from participating in growth 
in a vital part of the American economy because the current mar- 
ket structure is overly focused on cheap execution or cheap commis- 
sions. 

And, I think there is a balance here, which is why we have said 
there is a different regime, potentially, that could go on for the 
smaller companies. There is not a one-size-fits-all answer here. 
Five-dollar executions are great. I use them. I love them. But, you 
do not have to give that up and still foster capital formation and 
encourage price discovery. 

Senator Johanns. I have exhausted my time, but I do have one 
question. What percentage of trades on a given day or a given 
month would be the five-dollar execution versus the Andys of the 
world? 

Mr. Solomon. I do not think I have that information. I think one 
of the challenges that the exchanges and the SEC is determining 
is what actually constitutes a retail order flow. 

Senator Johanns. OK. 

Mr. Solomon. That is a hotly debated discussion point, because 
there is — I think people feel like if we are really, truly protecting 
individual investors, everybody is on board with that. But, there 
are people who masquerade around as individual investors who are 
really high frequency or professional traders who are accessing 
their five-dollar trading accounts, and that does not quite seem like 
it is right. And so it is very difficult, actually, to Imow. I cannot 
tell — and, by the way, everything trades in hundred lots today, so 
it is really hard to be able to discern between an institutional order 
and a retail order. There is no real way to capture that data, to 
the best of my knowledge. 

Senator Johanns. Thank you, Mr. Chairman. 

Chairman Warner. I think you raised a good point. Senator 
Johanns. The question I would have, and I am going to let Senator 
Warren get an extra couple minutes, is just that would that rugged 
individualist who gets the five-dollar trade be offended if somebody 
in that tiny spread is making perhaps inappropriate profits be- 
cause you have got the incentives misaligned? But, I imagine 
maybe Senator Warren might go down that direction. 

Senator Warren. 

Senator Warren. So, thank you, Mr. Chairman, and thank you 
all for being here. 



17 


And, I do. I want to pick up on that line. The question for me 
is not so much about the cost savings from all electronic trading, 
it is the question about the so-called high frequency traders. And, 
for me, the term “high frequency trading’ seems wrong. You know, 
this is not trading. Traders have good days and bad days. Some 
days, they make good trades and they make lots of money, and 
some days, they have bad trades and they lose a lot of money. 

But, high frequency traders have only good days. In its recent 
IPO filing, the high frequency trading firm Virtu reported that it 
had been trading for 1,238 days and it had made money on 1,237 
of those days. Now, I do not know what happened on the one bad 
day, but I assume a computer somewhere got fired. 

The question is that high frequency trading firms are not making 
money by taking on risks. They are making money by charging a 
very small fee to investors, and the question is whether they are 
charging that fee in return for providing a valuable service, or they 
are charging that fee by just skimming a little money off the top 
of every trade. 

So, let me start there. Mr. Brooks, the defenders of high fre- 
quency trading often claim that they provide liquidity to the mar- 
ket. There is always someone willing to buy whatever it is that in- 
vestor is selling. What is your view on that? 

Mr. Brooks. That is a great question. Senator. I think our view 
is that is a convenient answer by them. You know, the markets 
functioned pretty well prior to high frequency trading strategies 
being adopted. You know, if 95 out of 100 times that you have said 
you want to buy 100 shares of GE you canceled that trade, that ex- 
pression of trading interest before anybody can get to you, I sort 
of question the true intent of what you are doing. 

Now, I think it is important to be clear, some high frequency 
trading strategies are legitimate. They are market making. They 
are statistical arbitrage. They are buying stocks in a basket against 
an index or something like that. But, a lot of these strategies real- 
ly, our understanding — and by the way, I a^ee with both Mr. Sol- 
omon and Professor Scott, this market subject is incredibly com- 
plex — but, so much of what a high frequency trading strategy 
might be is to act, to draw a reaction, and then to profit from your 
reaction. So, they flank you. They pivot around you. They really 
have no intention of trading. They just sort of want to see what you 
are going to do, and once they know what you are going to do, they 
can step in front of you. 

Senator Warren. Right. So, you would argue this is not adding 
liquidity to the marketplace 

Mr. Brooks. We think there is a huge difference between liquid- 
ity and volume. They trump the liquidity side and we are, like, 
wow. Before you guys came along, we seemed to be fine, or seemed 
to be better, in some respects. 

And, I do think it is important here to identify that retail inves- 
tors declare victory. You are in great shape. The five-dollar trade, 
instant access, awesome. But, a big part of your portfolio, of your 
nest egg, might be invested with people like us. And, in that part 
of the market, it is not such a good trade because you have people 
that are taking advantage of your being in a market for a longer 
period of time. When you are buying 100 shares, you are there for 



18 


2 seconds and you are done. You declare victory. You go home. It 
is great. 

But, let us say you have a million shares to buy. I might be there 
all day, and all day, those other interlopers, if you will, have an 
opportunity to step in front of, take advantage of, sniff out our 
order, all those kinds of things. And, that is troubling to the mar- 
ket. That is where we could be better. 

Mr. Solomon. I also think, by the way, that there are — the li- 
quidity providers are there when it is convenient for them to be 
there. So, I would ask the question, are they really providing li- 
quidity, because I know if I am an individual investor and I want 
to sell and I am in a line with everybody else, they have no obliga- 
tion to be there. In fact, arguably, when that starts to happen in 
the market, the thing that concerns me most is all a lot of these 
algorithms look and tradeoff the same trends. So, if we start to get 
one-sided in the market in the other direction, they will widen 
their bids and offers and then we no longer have a market that is — 
has a responsibility to provide liquidity, a buyer of last resort. 

Senator Warren. So, if I am following you, Mr. Solomon, you are 
saying that they are really adding volatility to the market, volume 
to the market, without adding true liquidity to the market. 

Mr. Solomon. It can be true liquidity. It is just not true liquidity 
when you might actually need to get true liquidity, because there 
is no obligation. So, they will trade as long as there is liquidity, 
and we have seen in small caps, for example, when there is no ac- 
tivity, they do not trade until there is activity. Then, they trade. 
And, so, that is not really providing that liquidity. That is, like, 
moths to the flame. There is a flame. Let us fly there. 

And, so, that is not real adding — it looks to the casual observer 
as if there is a lot of volume, but is there real fundamental buyers 
and sellers or is it just a bunch of people crawling in there when 
they think there are real buyers and sellers around and creating 
activity that really does not add to the ability for Andy to aggre- 
gate a position or sell a position when he actually needs to do it. 

And, I worry about the stability of the marketplace because when 
there is going to be — there will be, it is a matter of when — when 
there is selling, I wonder who is going to be there to actually buy 
it, because in the old days, we may not have liked the New York 
Stock Exchange and the things that they did and the money they 
made, but they stood there and bought stocks in 1987, down big, 
but they bought them and the market opened the next day. 

And here, I am a little bit concerned, particularly around the 
Flash Crash. What happened there? You do not really need to do 
a lot of studying. A lot of algorithms said, oh, my God, this is un- 
usual. I am going to widen my bids and offers because I do not un- 
derstand what is happening. And then everybody did it. And, so, 
we are no better today in that regard than we were in 2010. 

And, I think, that is actually the challenge in market structure, 
as opposed to whether HFT is good or bad. It is the market struc- 
ture we live in, and HFT, sometimes it helps, sometimes it does 
not, but we are not in a good place market structure-wise. 

Senator Warren. All right. So, thank you, and — good. Actually, 
if I can just answer it, because the other argument you often hear 
is one about speed, that it speeds up the transactions. Mr. Brooks. 



19 


Mr. Brooks. So, our view on speed is, you know, if your request 
for speed is singularly focused, I think it is reckless. And, what we 
have been led to understand about market structure and the quest 
for speed is when you are interested in speed, you remove safe- 
guards and you remove some of the infrastructure and the 
underpinnings of the market. And, so, fortunately, we put in — the 
SEC put in the limit up, limit down, and some marketwide circuit 
breakers and that has been great. But, both the Flash Crash and 
Knight Capital situation were maybe driven by speed, and if that 
is the case, that is not good for anybody. 

As investors, it is rare — it is rare that speed is important to us. 
Our average holding period is, like, 3 years. Why do I really care 
what is going to happen in a nanosecond? 

Senator Warren. Well, I was going to say 

Mr. Brooks. I do not. 

Senator Warren. 1 take it the speed difference we are talk- 
ing about is measured is milliseconds 

Mr. Brooks. You cannot even blink 

Senator Warren. not in 7 days. 

Mr. Brooks. It is milliseconds, is right. 

Senator Warren. Yes. 

Mr. Brooks. It is nanoseconds. And, that advantage, that speed 
advantage, if it destabilizes, it seems to us that that is wrong. That 
is not right, and we ought to push back on that. Our view is, we 
really ought to just slow down, not walk away from technology, but 
let us take a deep breath here and really look at what we have, 
and I appreciate Professor Scott’s admonition about the complexity 
of the market. But, we have got to make some progress. 

You know, my boss says to me, “I do not really care how fast you 
are moving toward the goal, but please move in the right direction, 
will you?” If I am not moving in the right direction, I am in trouble. 
We have not been moving in the right direction. Oh, my God, we 
have got Dodd-Frank, we have got Volcker, we have got blah, blah, 
blah, all these things out there. They are always there. There is al- 
ways a reason why you cannot do it today. 

You know, we used to have a fellow that worked for us who used 
to talk about the phrase, “Today is the hardest day to invest.” 
There is always something that might preclude you from doing 
something. Today is the hardest day to go after difficult market 
problems, because, gee whiz, I have got something else I have got 
to worry about. 

Can we just start to make some progress? Please. We do not 
have the answers. Pilot programs give you the opportunity to gen- 
erate data. Let the academics run wild, try and figure it out. Move 
in very incremental, careful ways. It is right, you have to have a 
control. You have got to know what you are trying to study and 
measure for. But, we can do that, and I think we can do that in 
a constructive way. 

Senator Warren. Well, I want to say, thank you very much, Mr. 
Chairman, on this. You know, high frequency trading reminds me 
a little of the scam in office space. You know, you take just a little 
bit of money from every trade in the hope that no one will com- 
plain. But, taking a little bit of money from zillions of trades adds 
up to billions of dollars in profits for these high frequency traders. 



20 


and billions of dollars in losses for our retirement funds and our 
mutual funds and everybody else in the marketplace. It also means 
a tilt in the playing field for those who do not have the information 
or do not have the access to the speed, or who are not big enough 
to play in this game. 

So, I want to see the SEC, the State agencies push forward in 
their investigations, and I think we should continue to do the 
same. 

Thank you, Mr. Chairman. 

Chairman Warner. Thank you. Senator. 

We will actually get another — let us each take another question. 
I have got another question, if you want to take another quick shot 
at this. 

I just — I was in the technology business for a long time. The last 
thing you want to appear, particularly sitting in a chairman’s seat, 
is like a Luddite. But, I do kind of — do feel at times there may 
have been some — and I want Professor Scott to give a rebuttal to 
this a little bit — that technology for the sake of technology, when 
speed becomes so quintessentially important, when the opportunity 
to colocate becomes an advantage that clearly larger firms have 
over smaller, and the ability to get your — where you locate your ex- 
change becomes such a — the real estate decision becomes such a 
critical question. 

And, I know that. Professor Scott, you said that the volatility has 
not increased. I actually thought that the intraday — again, vola- 
tility has gone up 5x since 1996. I want you to kind of mention 
that. 

And, I do, and I do not know if any of you cited this study, but 
the study that shows the millennials are investing in the market 
at a lower percentage than anyone else. Now, is that a question of 
just financial uncertainty or is there — ^you would think, from the 
generation that would be more technology competent, there would 
be more willingness to accept this, but there seems to be perhaps 
a wariness amongst young folks that perhaps the system is being 
gamed. 

Comments? Thoughts? 

Mr. Scott. I would like to say at the outset that when we talk 
about the market, we are talking about lots of different trading 
systems in that market. And, one of the stories of Flash Boys was 
the attempt to design a better market, lEX. So, there is maker/ 
taker, there is taker/maker out there. So, part of what we have to 
think about when we look at this is what are people gravitating to? 
If you give them taker/maker, are they using that system, or do 
they find something else that is wrong with it? So, the market is 
not just one thing that is working in the same direction, a lot of 
different trading systems, a lot of different ways to trade. 

All right. Now, let me address your question. Senator, on vola- 
tility. There are many ways to measure it, OK. You can do it 
intraday, in which it is going up. You can do it day to day, week 
to week. I would say long-term investors who are key to the capital 
formation of our country are less interested in the amount of 
intraday volatility, you know, except for those people who are out 
sitting there on E*TRADE just trying to make a profit in 1 day. 



21 


We are talking about long-term investors, and it seems to me that 
their horizon on volatility is shorter than intraday. 

The second thing I would say on volatility is that the CBOE Vol- 
atility Index, so-called VIX, has fallen to its lowest levels since 
2007. What they measure is the 30-day expected volatility of the 
S&P 500. So, there is still a different measure that shows very low 
volatility. 

Whatever the volatility is, or is not, it remains to be seen what 
high frequency trading’s impact is on that volatility, because vola- 
tility — and this comes back to a question you asked — is driven by 
a lot of factors, only part of which, and maybe even a small part 
of which, may be trading system. We have been, since 2008, in a 
state of high uncertainty as to the future of our economy, OK, and 
that in and of itself — OK, every day, oh, I think we are OK, no, we 
are not OK, we have got this data, we have got that data — that 
kind of environment, where you are not certain of where we are 
going, produces volatility. And, so, I think the question, is the vola- 
tility coming from high frequency trading or it is coming from 
something else. 

On all of these issues, we need more understanding, more trans- 
parency, more information, OK, which is, hopefully, the SEC is 
going to provide. 

Now, in terms of the millennials issue, so, you know, the ques- 
tion is, are younger people in this country increasingly sort of 
afraid to invest in the market? When those people were questioned, 
only 5 percent of them actually said that they had an aggressive 
risk tolerance. So, what these people are saying is that we are very 
conservative. We have a risk aversion. That 5 percent is a pretty 
low number. And, so, you have to then ask, well, why are they risk 
averse? Is it because there are high frequency traders operating out 
there? I do not think so. It is because of the nature of what we 
have seen in the market and great uncertainty about our economic 
future. And, I think, that is what is preventing people from invest- 
ing. 

Now, that being said, Japan has had a longstanding problem of 
not getting people into their markets, and I think some people 
might analyze the reason for that as that the people do not trust 
the fairness of that market. So, we should not neglect fairness as 
a possible explanation, but there are powerful economic fundamen- 
tals here, in my view, that have been driving volatility and been 
driving less investor confidence. 

Chairman Warner. Thank you. We will go to Senator Reed and 
then back to Senator Johanns. 

Senator Reed. Well, thank you very much, Mr. Chairman, and 
thank you, gentlemen, for your testimony. I apologize. I had to be 
down at the Defense Appropriations hearing with Secretary Hagel 
and the Chairman of the Joint Chiefs of Staff. 

But, Mr. Brooks, in 2012, you were here before and testifying 
and 

Mr. Brooks. Nice to see you again. Senator. 

Senator Reed. Yes, sir, and it’sgood to see Professor Scott. As I 
said, previously, he led me to great intellectual waters, but I did 
not understand how to drink, so thank you. 



22 


But, in 2012, before the publication of Mr. Lewis’s book, you 
mentioned that there were many investors that were sort of turned 
off by the casino-type environment that they sensed, rightly or 
wrongly, and your clients, has that distrust, mistrust, or cynicism 
grown in the last 2 years? 

Mr. Brooks. I do not know whether it has grown, but I also do 
not think it has abated. So, you know, we talked about the percent- 
age of the households in this country that have exposure to the 
stocks at sort of 16-year lows and the millennials. I do not know 
what draws people to a market or away from investing, but that 
is not a good thing. You cannot save for your retirement if you do 
not generate some sort of return. So, we are pretty concerned about 
this whole issue. 

The job of trying to affirm a market’s reasonableness, its fair- 
ness, its transparency, seems to us to be ongoing, and we have sort 
of — we are not doing a good enough job there collectively as an in- 
dustry and everybody to try and affirm the reasonableness and 
fairness of our market. So, we continue to be concerned about that 
issue. 

Senator Reed. I think everyone has commented that high fre- 
quency trading has provided some significant advantages to mar- 
ketplace liquidity, and in some cases probably narrowing price 
spreads, et cetera, but, again, going to particularly this popular 
perception argument that some of it seems to be algorithms that 
are cleverly designed to essentially not make economic invest- 
ments, but to exploit sort of timing gaps in the system and other 
gaps in the system. You know, one of the things that is referred 
to is the sort of algorithms that will send out a huge number of 
bids and then cancel the bids, not because of the market activity, 
just simply because that is how they think they can move a price 
just a few basis points and then make the right move. That seems 
to me to be behavior that does not add to the economic value of the 
country, but it certainly makes some people very wealthy. 

Mr. Brooks. We would agree with that, and sort of following up 
on what Professor Scott was talking about, intraday volatility, in- 
stitutional investors who are really aggregated retail — it is every- 
body together, because that is who we represent — we do care about 
intraday volatility because it is in that environment that we are 
trading. It is in that environment that we are making our invest- 
ment to hold something for 5 years. And, if a trading strategy — if 
someone has been able to exacerbate that volatility between 9:30 
and 4, I would argue it is causing longer-term investors a higher 
cost. 

Senator Warren sort of talked about a tax. That is sort of a tax 
on the system. All the money that the high frequency crowd is tak- 
ing out — they are not taking risk overnight, they are flat every day, 
they never lose money — all the profits they are making are coming 
from someone else. That might be the longer-term investors, every- 
body in their 401(k)s, their 529 plans, et cetera. 

So, we are very concerned about intraday volatility and that is 
why we would like to see some pilot programs to examine, can we 
constrain that a little bit? Can we make the markets a little deep- 
er, a little more transparent to bring that intraday volatility in, 
narrow it? We do not have the answer until we try. 



23 


Mr. Solomon. We agree with that 

Senator Reed. Let me go to Mr. Solomon, and then I will ask 
Professor Scott just to comment on the general sort of discussion 
that we have initiated with Mr. Brooks. Mr. Solomon. 

Mr. Solomon. Yes, Senator. We agree completely. Actually, we 
are very much on the same side here. The intraday volatility in 
single stocks has actually, in some instances, never heen higher. 
When a buyer shows up, the stock lifts inexplicably, and when a 
seller shows up, the stock drops inexplicably. So, I do not really 
think there are a lot of good measures for single stock volatility. 

I think, with all due respect to the Professor, I do not think the 
VIX has anything to do with this. The VIX is an irrelevant — it just 
looks at overall market volatility and all it says is that, you know, 
generally speaking, people are, you know, sanguine about the over- 
all market, in general, macroeconomically, even with all the wor- 
ries. They are generally sanguine. When they are not sanguine, the 
VIX will be 40. But, it does not impact what happens in single 
stocks. 

There are some definite issues here that are exacerbated by the 
market structure, and high frequency — some high frequency trad- 
ers that do engage in flash trading behavior, in particular, are 
harmful, I mean, and I do not think there is anybody that can 
argue about that. 

But, if you look at the reason why people flash, it is because a 
lot of the trading goes on in the dark. So, dark pools are, by their 
definition, not transparent. So, if you want to trade in a dark pool, 
well, you need a way to light that dark pool, and one of the ways 
you can light that dark pool is by flash trading and seeing where 
the bids and offers are. And, the question is whether or not dark 
pool operators encourage that kind of behavior or discourage that 
kind of behavior. 

At Cowen, we do not run a dark pool and we are not interested 
in running a dark pool. We have access to a lot of different liquid- 
ity providers and we have developed algorithms to help folks like 
Andy access pockets of liquidity and combat that kind of behavior. 
So, there are some market clearing mechanisms that allow you to 
deal with that. But, in general, if you do not have the kind of algo- 
rithms we have to combat that kind of behavior, you are at a sig- 
nificant disadvantage. 

I would also say, when people talk about speed, there are plenty 
of analogies we could use about speed and what it does. We can 
all say that the National Highway System increased the produc- 
tivity of this country in ways that even President Eisenhower could 
not imagine. But, we have speed limits. Every car on the highway 
can go faster than it is allowed to go. So, it is OK for regulators 
and legislators to say, we know you can go faster. We know you 
can make improvements in efficiencies of your engines. But, we 
think that this is the right speed to encourage the right kind of eco- 
nomic behavior and protect investors. 

So, I do not think you are actually being a Luddite at all by ask- 
ing the question, just because we can go faster, should we go faster, 
and there are plenty of examples like that one that suggest we 
might not be better. 



24 


Senator Reed. Thank you. Thank you very much. Just a last 
word, if I may prevail upon my colleagues. 

Senator Johanns. Sure. Go ahead. 

Senator Reed. Thank you, Mike. 

Professor, please. And, welcome. Good to see you. 

Mr. Scott. Thank you. Senator. I think we need to keep our eye 
on the ball. The ball is, you know, what is best for people who are 
trading in this market and what do they care about, and in turn, 
what is best for our economy? So, we talked about three different 
elements in the market. We talked about volatility. We talked 
about liquidity. We talked about transaction costs. OK. 

So, on volatility, I have already said, people disagree on this. It 
depends how you measure volatility, OK. I still am of the view 
where maybe traders get rewarded for a little less volatility during 
the day. Does a long-term investor really care about intraday vola- 
tility? The people who are trading for them may care because they 
get compensated on basically how they do. But, for the long-term 
investor, I have to say, I am in TIAA-CREF and I could care less 
about intraday market volatility. 

Now, the second part of it is liquidity, OK. People are obviously 
interested in being able to trade in and out of their stock positions 
when they want to. This is retail and institutional. And, here 
again, we have a lot of data, all right, an economist that says, li- 
quidity overall in this market is an all-time best. And, yet, Jeff, 
OK, when he deals with small cap stocks, he does not see that be- 
cause we are measuring the overall market, which is dominated by 
large cap stocks. So, if we have a liquidity problem, I think it is 
targeted — should be targeted, and I think Jeff would agree with 
this, at trying to get more liquidity in small cap stocks. We do not 
have that liquidity. Therefore, people do not want to invest in 
them. Therefore, we do not have capital formation. 

And, the third thing is transaction costs, and this goes back to 
Senator Johanns’ questions or observations. You know, retail costs, 
I think everybody would agree, are at an all-time low. Nobody here, 
I think, has said that is not the case. On the institutional side, we 
have studies by financial economists — there was just a recent study 
by Angel, Harris, Chester Spatt, they are all pretty well recognized 
financial economists, who say the average transaction cost for an 
institutional order of one million shares for a $30 stock is at a his- 
toric low of 40 basis points, OK. So, we have to reconcile that con- 
clusion with what Mr. Brooks is observing. I am not saying Mr. 
Brooks is not observing higher transaction costs, but here is a pret- 
ty well respected group of financial economists who are saying it 
is at an all-time low. 

So, I come back to Senator Johanns’ process question, really. 
There are a lot of differences of opinions on these issues, OK, and 
it is, in my view, the SEC’s first role to sort this out, write a good 
report for our country, including for this Committee or for the 
greater Senate Committee and the House, and then we will have 
something, OK, to look at and react to. 

So, I think, again, we should not be legislating now on these 
issues. We should be fact finding and the primary fact finder 
should be the SEC. And, by the way. Senator Reed, when you were 



25 


out of the room, I am very much in favor of the SEC having ade- 
quate funding to do this and other things. 

Senator Reed. Thank you very much. Thank you, gentlemen. 

Senator Johanns. Go ahead. 

Mr. Brooks. Could I possibly respond to 

Senator Johanns. Mr. Brooks, you wanted to 

Mr. Brooks. So, there are lots of studies out there talking about 
transaction costs, and you can pretty much find a study to match 
any opinion you want to espouse. There is an RBC study out saying 
that intraday volatility costs are now perhaps higher than ever, 
and we are seeing that in our trading. And, I know Professor Angel 
and he is a good guy and he does good work, but it depends what 
you are examining, and so that is a very complicated subject, too, 
talking about transaction costs. 

Two other things we have all sort of talked about here today are 
conflicts of interest and complexity, and we could be better if we 
could eliminate conflicts of interest and reduce complexity, and I 
want to just tell you a quick story, a trading story. 

So, one day a few years ago, T. Rowe Price, we had 2.5 million 
shares to trade in a number of different stocks and we picked a 
broker and they were about our number 7th broker on the day in 
terms of the business we did. That 2.5 million shares got rep- 
resented out to the marketplace as 750 million shares of interest, 
300-to-one. So, we had 2.5 million shares to buy. It got displayed 
in different times, different ways, as 750 million shares, simply to 
get 2.5 million shares executed. 

Now, was that a great trading strategy? The numbers looked 
pretty good. The reality is, we have 11 exchanges and 50-plus dark 
pools. That complexity, that myriad of — that spider web out there 
of where you have to go to trade today has created all kinds of 
challenges for every investor, and it is that issue that we need to 
try and focus on. How crazy is it that you have to go to so many 
different places to say, anybody there? Anybody want to trade? 
Anybody care today? We are really — we are obfuscating things, and 
people have been able to figure out ways to profit from that that 
really cause them to take no risk. 

Mr. Solomon. I am willing to bet that that was a large capital- 
ization stock, too. 

Mr. Brooks. They were across the spectrum, actually. 

Mr. Solomon. Right. And, so, if you look at what happens in 
small cap stocks — sometimes, you know, it is like — we call it the 
Hotel California. If you own a small cap stock, you can check out 
any time you like, but you can never leave. And, that is a problem 
when it comes to capital formation. 

And, we talk — prior to the JOBS Act, which was to get compa- 
nies to think about going public, private companies, we seem to 
have established a really good regime in the Congress where we 
can do good legislation that balances investor protections and cre- 
ates a forum for capital formation. But, once these companies are 
public, who is actually sponsoring them and how is that trading oc- 
curring? 

And, we are in a period now where we have a number of new 
companies, and we would love to give them the right kind of expe- 
rience to encourage further investment in capital-intensive busi- 



26 


nesses from your venture capital friends who right now, if you look 
at the last 10 years of venture capital investment in this country, 
it is disproportionately in companies that do not hire lots of people, 
or are not capital intensive. We do not hack semiconductor manu- 
facturing companies in this country anymore. That is a problem. 

And, so, if you need access to capital heyond the venture spec- 
trum, you have to find it in the public markets, and this is what 
we are talking about. There needs to be that liquidity. 

Chairman Warner. Senator Johanns gets his question. 

Senator Johanns. Maybe more of an observation than a ques- 
tion, and here would be my observation. I came to this hearing 
today wondering about the process question — that is why I asked 
it first out of the box — just simply because we, years and years ago, 
created an SEC. We gave them authorities. We have looked at that 
from time to time. We have broadened their authority and we have 
said to them, we want you to be the experts. We want you to un- 
derstand this marketplace and report to us on what is working and 
what is not working. 

And, I leave this hearing today more and more convinced that if 
there is direction from Congress, it should be direction to the SEC 
to go out there and find the facts, report back, do the pilot pro- 
gram — which, incidentally, I have no problem with. 

The second observation is this. What traders are doing is not ille- 
gal. If they are out there buying and selling and doing what they 
are doing within the laws that are currently on the books, they 
have a right to do that. And, it occurs to me, Mr. Brooks, that they 
have kind of outsmarted you, not because you are less intelligent 
than they are, but they watch you like a hawk and all of a sudden 
they are starting to figure some things out and they are just a sec- 
ond ahead of you and it is profitable. 

Now, I would not be smart enough to do that. I guess if I were 
that smart, I would be doing that instead of what I am doing now, 
right? 

Chairman Warner. You are not running for reelection, though, 
right? 

Senator Johanns. Yes. 

[Laughter.] 

Senator Johanns. I will not be doing that in my next life. 

All I am saying to you is before we head out there in a free mar- 
ketplace and start defining behavior to be illegal, we should be 
darn sure about what we are doing, because it could have some 
economic consequences. 

Now, I want you to go out and give me the very best deal, and 
I do not think I am invested in your company whatsoever, but I 
do have a retirement program here that I have got some money in, 
and I tell you what, I look at the statement and I say, way to go. 
Good job. You are making more money for me. I want you to do 
that. 

But, having said that, again, I think we need to be very thought- 
ful about when we proclaim behavior to be illegal in a free market 
system, and that one, I must admit, I want more information on. 
I want more fact finding. I want to understand who wins, who 
loses, what is the consequences. And, I do not think we are any- 
where near there at this point. 



27 


Like I said, I leave this hearing with somewhat the same impres- 
sion I came to the hearing with, and that is we need the SEC out 
there to lead this effort. We need to encourage them, fund them, 
do those things. And then a future Congress — this will happen 
after I am gone — needs to be careful and thoughtful about how 
they are going to figure this out, because just because they are 
making money does not warrant us jumping in and saying, that be- 
havior is illegal. You are making money. That has got to be illegal 
behavior. 

Mr. Brooks. Senator, I think that is a — your point is well made. 
I do not think we are saying this behavior is illegal, but it might 
not be fair. It might not be right. It might not be ethical. So, if 
someone gets an information advantage about my trade and they 
get it — they get knowledge of a trade that is going to happen, and 
it happens and they are able to profit from that knowledge before 
the rest of the market can, when it is really marketwide knowledge 
that should be shared, I am not sure that advantage is right. 

I have no problem with people making money. I mean, we are 
a for-profit enterprise. This is America. We believe in that. But, 
when you take an unfair advantage or you found an unfair advan- 
tage and you have exploited that, I think that maybe the SEC 
needs to gut-check that and come back and say, maybe we can 
tweak things, because that is not fair. 

That is why I think the tax loophole analogy is a good one. You 
know, we respect people that found ways to avoid paying taxes, but 
if it is a loophole, it often needs to be closed. And, we think that 
some of these predatory practices are, in fact, not fair and not right 
and they should not be allowed to go on. It is not that they are ille- 
gal, but they have an unfair advantage. 

You know, my mother used to say to me, “Just because you can 
do it does not mean it is right,” and I think that is important. 

Senator Johanns. You know, and I got the same lesson. 

Mr. Brooks. Yes, sir. 

Senator Johanns. I got the same lesson, and I do not agree with 
the philosophy you espouse, and I hope I live by that philosophy. 
But, again, highly technical, critical that we get good information 
from the SEC, critical that we understand what the consequences 
of our actions might be, because at the end of the day, there will 
be consequences. And what we stop here may open something up 
over here that we do not like any better. Like I said, I just think 
we need to be very careful, very thoughtful. 

I have not read the book. I am sure it is a great read. Mr. Lewis 
is a fascinating author. But, having said that, this is very serious 
business, and if there is anything I take from this hearing and 
three outstanding panelists, in my judgment, is we need to be 
thoughtful about where we head from here. 

Mr. Solomon. This is why we have advocated for pilots. I think 
if there is one consensus, we have all said that there should be pi- 
lots and we should observe those pilots and make changes based 
on the information we gather from that. 

I will just say, there is a little bit of a difference at the SEC now 
than there was when the JOBS Act was passed. Chairwoman 
White has really made this a priority. She is data-driven. She is 
going to do a lot of analytics. And, she has been very consistent in 



28 


her commentary, as have the other Commissioners. So, I do think 
that we can mayhe get some answers from them. 

But, I will say that the first thing that came out that was re- 
quired — the JOBS Act required the SEC to look at market struc- 
ture, and I would encourage you to read that report and see if you 
learned anything from that. And, I would say, part of the reason 
why we formed the Equity Capital Formation Task Force is we 
looked at that report and said, it did not tell us anything. So, we 
have to advocate for them to actually tell us something that is 
helpful. 

And, I am hopeful that under this leadership of Chairwoman 
White that we will get a different outcome, but I think it is Con- 
gress’ responsibility to ensure that we get that output, and that is 
part of the reason why I am here, at least. 

Chairman Warner. Let me — and, again, I appreciate everybody’s 
comments and, I think, the very good questions. And, I think. Sen- 
ator Johanns and I have worked on a lot of things together. We get 
the conflict. We have got the value-add to the economy of the retail 
investor being able to get that cheaper price. 

But, I do think the notion, and I am a proud free market advo- 
cate and proud of my experience longer in business than I have 
been in politics, but there is this notion in the market, you take 
risks and you take your lumps and you take your wins. Something 
that is inherently — a track record that says if 99.9 percent of the 
days in a trading exchange you make money — and it is not just an 
HFT, I recall some of the large cap banks who had those same 
records — it creates at least something that is echoing what you 
have said. We need more data. 

And, I come back to the fact. May 13, not May 13 in 2010, but 
May 13 in 2014, Xerox and Lorillard, this was the — we had a 
minifiash crash. And, if we were to have another one of these inci- 
dents, the tendency would be, as you know. Senator, we might 
overreact too quickly. So, the fact that we are 4 years after the first 
Flash Crash — and I remember the previous Chair of the SEC, ask- 
ing her what happened, and months and months later, they were 
still trying to find out — the fact that we do not have that consoli- 
dated audit trail information done — I mean, I am for adequate 
funding for the SEC, as well, but at some point, the priority — this 
needs to be a higher priority. And, I do think we have a role to 
nudge the SEC to act, to make this a higher priority, to urge our 
colleagues on both sides of the aisle to get the SEC the resources 
they need to do their job, number one. 

I think, at least, I, and I think you have concurred on the tick 
size, the pilot, the notion of small caps. We want to try to accel- 
erate that. 

But, there are — I think Mr. Brooks has raised some fundamental 
questions about this notion of fairness here that we do not have all 
the appropriate data to kind of make that judgment. And, my con- 
cern will be, if we do not have that data soon, another incident will 
happen, and, my gosh, because of the complexity. Congress trying 
to line-by-line legislate this would not be a pretty activity. 

All right. Professor Scott. Briefly, because we are about to bring 
the hearing to an end. 



29 


Mr. Scott. I just want to put in a plug. Our committee has got 
a full-scale project to examine all these market structure issues 
and we will be doing so over the next 9 months. So, I want to say, 
the SEC is not the only organization out there that is going to be 
studying market structure. Our committee is doing it. I am sure 
there will be others for you to look at and sort of weigh those other 

studies against whatever the SEC 

Chairman Warner. And, I would say this. One of the things I 
think this Subcommittee needs to do, since we have this as our ju- 
risdiction, and Senator Levin had some of the folks yesterday, but, 
you know, we need to have some folks — ^back to Mr. Brooks’ point 
about how many exchanges there are out there competing, it 
should be very, very small. You would have to search out these 
very, very small exchanges. On the other hand, in the notion of a 
market, they need to have their say in this Committee, as well. 

I want to thank all the witnesses for very focused answers and 
appreciate your contribution. Senator Johanns, thanks for your 
contribution, as well. 

The hearing is adjourned. 

[Whereupon, at 11:29 a.m., the hearing was adjourned.] 

[Prepared statements and additional material supplied for the 
record follow:] 



30 


PREPARED STATEMENT OF HAL S. SCOTT 

Nomura Professor and Director, Program on International Financial 
Systems, Harvard Law School 

June 18, 2014 

Thank you. Chairman Warner, Ranking Member Johanns, and Members of the 
Subcommittee for permitting me to testify before you today on the impact of high 
frequency trading on investor confidence and capital formation in U.S. equity mar- 
kets. I am testifying in my own capacity and do not purport to represent the views 
of any organizations with which I am affiliated, although some of my testimony is 
based on the work of the Committee on Capital Markets Regulation (CCMR). On 
the whole, high frequency-trading increases liquidity in our equity capital markets. 
The increased liquidity leads to decreased costs of stock issuance, thus improving 
capital formation. And of course, improved capital formation for our businesses 
leads to higher growth in the real economy. 

The Committee was formed in 2005 to address the issue of competitiveness in our 
primary public equity capital markets and issued a report in 2006 detailing the 
threats to our primary markets and suggestions for improvement. ^ Just as regu- 
latory changes can lead to competitiveness concerns in our primary markets, the 
same is true of our secondary markets. Therefore, any changes in our secondary 
market trading must be assessed for their competitive implications, particularly 
given the current relative competitive strength of our secondary markets vis-a-vis 
those abroad. 

The CCMR tracks, on a quarterly basis, 13 measures of the competitiveness of the 
U.S. public equity market. ^ We have found that while the competitiveness of our 
primary markets has suffered over the past 6 years, our secondary markets remain 
strong with roughly 50 percent of global exchange trading occurring on U.S. ex- 
changes. ^ The CCMR is currently undertaking a review of market structure issues 
with a focus on dark pools, internalization, decimalization, exchange backup sys- 
tems, and the subject of today’s hearings, high frequency trading. 

“High frequency trading” or “HFT” is a topic that has generated significant atten- 
tion in recent years and increasingly in the last few months. The widespread public 
interest in this topic was intensified following the 2010 “flash crash” and more re- 
cently, with the publication of Michael Lewis’ book Flash Boys, which has ignited 
a general attack on HFT’s place in the U.S. capital markets. But policy cannot be 
made on the basis of a journalistic tale that makes for a best seller — rather it must 
be informed by verifiable facts. This is largely why we are here today and my inten- 
tion is to provide a thoughtful response to a debate that has been at times fraught 
with frenzied emotion. 

Let me be clear at the outset, that I believe the net effect of HFT activity in our 
equity markets has been positive. Transaction costs are at historic lows, liquidity 
is at historic highs, and volatility has stabilized. These features of today’s market 
not only benefit both retail and institutional investors, but also positively affect cap- 
ital formation, and by extension, promote job creation. The fact that HFT is the sub- 
ject of a best-selling book and has generated vocal opposition both within the finan- 
cial industry and across the American public more broadly, does not, in itself, justify 
drastic regulatory change. There is nothing new about the advantages of speed to 
traders. You may recall that the Rothschilds used carrier pigeons to bring them 
news of the outcome of battles in the Napoleonic wars. * While the speed with which 
they obtained this information gave the Rothschilds an advantage, the markets gen- 
erally benefited from the speed by which the new information got into the market, 
even if those who actually traded with the Rothschilds were at a disadvantage. 

My primary concern is that the recent frenzy over HFTs draws attention away 
from other important market structure issues. For example, as a member of the Eq- 
uity Capital Formation Task Force, along with my fellow panelist Mr. Solomon, I 
have been highly supportive of a tick-size pilot program for small cap stocks and 
have been encouraged by the SEC’s recent commitment to conduct such a program. ® 


1 Comm. On Capital Mkts. Reg., Interim Report of the Committee on Capital Markets Regula- 
tion (Nov. 30, 2006), http: !! www.capmktsreg.org ! pdfs ! 

ll.SOCommittee Interim ReportREV2pAi. 

2 Comm, on Capital Mkts. Reg., Competitiveness Measures, http:llwww.capmktsreg.orgl 
educationresearch I competitiveness-measures / 

Old. 

^Mary Blume, “The Hallowed History of the Carrier Pigeon”, New York Times, Jan. 30, 2004. 

^See Letter from Hal S. Scott to Joseph Dear, Chairman, Inv. Adv. Comm., U.S. Sec. and 
Exch. Comm. (Jan. 23, 2014), available at http:! I www.equitycapitalformationtaskforce.com ! 
fdes IH%20Scott%20IAC%20letter%202014%2001 %2023.pdf 



31 


That being said, to the extent that public concern over HFTs reduces investor con- 
fidence, our capital markets will suffer. But in my opinion, any reduction in con- 
fidence would not be based on the facts. Given the recent volumes in trading, there 
is little evidence that people have lost confidence in our markets. 

Critics of HFT point to the $261 billion that retail investors have pulled from eq- 
uity mutual funds since the 2010 “flash crash” as evidence that investors have lost 
confidence in our equity markets. ® However, retail investors have simply moved 
their investments to exchange traded products, which of course trade in U.S. equity 
markets. The net effect is investor inflows of almost $500 billion since the 2010 
flash crash. In 2012 alone, there were net inflows of $57 billion in securities trad- 
ing in U.S. equity markets. ® If investors were indeed overly concerned by HFT then 
they wouldn’t have added such substantial amounts to their capital at risk in our 
equity markets. 

Another common misconception regarding HFT and our current equity market 
structure is that HFTs have somehow caused an increase in transaction costs for 
individual retail investors. In fact, transaction costs for retail investors are at his- 
toric lows, as evidenced by current bid-ask spreads and retail brokerage commis- 
sions. Since 2006, the average effective bid-ask spread on NYSE-listed stocks has 
dropped in half, from over 3 cents to roughly 1.5. ® Retail brokerage commissions 
are also at all-time lows; the average commission charged by the three major retail 
brokers is approximately $10 per trade. Given the reduction in spreads and com- 
missions, the net cost of a given trade has dropped dramatically for retail investors. 
According to the Tabb Group, 7 years ago retail investors’ effective payments on exe- 
cuted trades were roughly 130 percent of the NBBO spread (the difference between 
the national best bid and offer). Since then they have dropped to less than 100 per- 
cent, so the average retail investor receives a better price on a trade than the best 
price available on an exchange, In short, it is a great time to be a retail investor. 

However, bear in mind that retail investors only directly account for approxi- 
mately 15-20 percent of daily stock market volume. Since many retail investors 
access the equity markets indirectly through institutional funds or advisors (such 
as mutual funds, pension funds, or private wealth advisors), institutional cost reduc- 
tion is highly relevant to retail investors as well. In 1950, over 90 percent of U.S. 
equities were held directly by households. That number has dropped to less than 
40 percent in 2013 and this is primarily high-net worth individuals. Household 
ownership of mutual funds has risen from 5.7 percent in 1980 to 46.3 percent in 
2013 constituting 90 percent of mutual fund assets, Collectively mutual funds own 
30 percent of the U.S. stock market capitalization, i® Clearly, what is good for insti- 
tutional investors is also beneficial for the small investor. 

The institutional investors that primarily trade on behalf of the small investor 
constitute roughly 25-35 percent of average daily stock trading volume in the U.S. 
And today institutional trading costs are historically low. Based on institutional 
trade data compiled by leading finance academics, the average transaction cost for 
an institutional order of 1 million shares for a $30 stock is at a historic low of 40 
basis points. This includes additional costs associated with price movement from 
information leakage. The costs of trading these large orders can exceed bid/ask 
spreads if there is information leakage that a large order is being placed and the 
price of the trade subsequently moves against the buyer. To prevent this, institu- 
tional traders split large orders into small orders for execution to avoid tipping off 
other market participants that a large order has entered the market. Neither retail 
nor institutional investors appear to have suffered from the increase in HFT trading 


® Justin Schack, “HFT Is Not Driving Investors From the Stock Market”, Fin. Times, May 10, 
2013. 

’Id. 

8 Id. 

8 See James J. Angel, Lawrence E. Harris, and Chester S. Spatt, “Equity Trading in the 21st 
Century: An Update”, June 21, 2013. 

“Id. 

’’See “The Citadel Conversation”, Q1 2013, available at https:! I www.citadelsecurities.com I 

files / uploads i sites 12 j 2013 i 06 j The-CitadeTConversation-with-Larry-Tabb-and-Jamil- 

Nazarali.pdf. 

’8 Rosenblatt Securities estimate. 

’8B. Friedman, “Economic Implications of Changing Share Ownership”, Journal of Portfolio 
Management 22 (Spring 1996). 

’’Board of Governors of the Federal Reserve System, Flow-of-Funds Accounts (2013). 

’8 Investment Company Institute, 2013 Factbook. 

’8 Id. 

’’Rosenblatt Securities estimate. 

’8 See James J. Angel, Lawrence E. Harris, and Chester S. Spatt, “Equity Trading in the 21st 
Century: An Update”, June 21, 2013. 



32 


activity. If anything, market participants are experiencing the best trading condi- 
tions ever seen. 

In addition to transaction costs, market volatility and more importantly severe 
market dislocations are also a primary concern for all investors. Critics of HFT con- 
tend that HFT strategies have led to a significant increase in stock market volatility 
caused merely by HFT trading activity, rather than changes to the fundamentals 
of stocks. However, respected market structure experts continue to believe that vola- 
tility is largely driven by macroeconomic concerns and not HFT activity. Stock mar- 
ket volatility, as proxied by the CBOE Volatility Index (VIX), understandably rose 
during the heart of the financial crisis, but has since fallen to its lowest levels in 
seven years. Intraday volatility of individual stocks also remains low. Professor 
Larry Harris has found that there is no clear pattern that stock market volatility 
or the intraday volatility of individual stocks has accompanied the rise of HFT. 
And while the extreme volatility experienced during the flash crash in 2010 was a 
significant market disruption that should not be repeated, the SEC has largely ad- 
dressed this concern by implementing single-stock circuit breakers and revising 
marketwide circuit breakers that will temporarily halt trading if price movements 
become too volatile. 

Thus, it is hard to argue that the U.S. equity market is “broken” as a result of 
the emergence of HFT activity. Nonetheless, there is always room for targeted im- 
provement of the current regulatory structure, including with respect to certain 
practices of HFT traders. But we should proceed cautiously and thoughtfully so as 
not to chill legitimate market functions. There are risks to implementing any 
changes which must be assessed — for example, bid/offer spreads could widen or ex- 
change volumes (and with it liquidity) could drop. 

As a first step, we must precisely identify what practices warrant further regu- 
latory scrutiny. Defining high frequency trading is far from straightforward. For ex- 
ample, many institutional traders place relatively small trades with high frequency, 
but whether this is a unique and potentially abusive investment strategy or whether 
this is simply an optimal trading strategy that has evolved with automated trading 
(e.g., to execute a large block trade without exposing the size of the order), is a base- 
line question. Technological advances mean that modern trading is done electroni- 
cally with orders no longer being given to a broker on an exchange floor. And trad- 
ing is getting faster every year. We can’t put the genie back in the bottle; Mary Jo 
White recently acknowledged that “the SEC should not roll back the technology 
clock.” 

At the same time, there are certainly many general risks that come with auto- 
mated and faster trading. We need to make sure our rules keep up with industry 
technology. Regulation has not kept pace with technolo^cal advances. As Mary Jo 
White acknowledged, “many market structure rules and industry practices were de- 
veloped with manual markets in mind.”^'^ We have seen other significant changes 
in response to modern technology before — for example, following the October ’87 
crash, when the NYSE implemented marketwide circuit breakers in response to the 
recommendations of a presidential task force. 

Market instability is something everyone agrees we need to avoid, to the extent 
possible. In our fast-paced world, our markets are particularly susceptible both to 
fat finger mistakes and errors, as well as intentional, manipulative behavior by cer- 
tain market participants. The incredible speed at which we now trade can exacer- 
bate errors, and quickly. 

We need to ensure the safety and soundness of our markets. Fortunately, as I 
have previously mentioned, the SEC and securities industry have already taken a 
number of steps to address this topic. For example, in addition to circuit breakers, 
the SEC has issued requirements for market participants to address technology 
risks through the Market Access Rule and proposed Regulation SCI. The Consoli- 
dated Audit Trail is expected to be operational in 2016 and will provide the SEC 
comprehensive data regarding the routing and execution of orders, allowing regu- 
lators to better prevent, identify and respond to any firms engaged in harmful prac- 
tices. 

Critics of HFT contend that HFT firms have access to proprietary data feeds from 
the exchanges that provide them with information before other traders, allowing 


“Id. 

2°Mary Jo White, Chair, U.S. Sec. and Exch. Comm., “Enhancing Our Equity Market Struc- 
ture”, Speech at Sandler O’Neill & Partners, L.P. Global Exchange and Brokerage Conference 
(Jun. 5, 2014). 

21 Id. 

22 See NYSE Circuit Breakers, available at https: ! I usequities.tiyx.com I markets I nyse-equities ! 
circuithreakers. 



33 


them to “front run” the market. However, it is important to be clear that trading 
on information that is publicly available is different than a broker trading ahead 
of a customer, which is patently illegal. Michael Lewis points out examples in which 
he claims that HFT traders obtain an advantage in the market when brokers trade 
only a small portion of a larger customer order with the HFT to gain a rebate on 
that small portion. The HFT then uses the information from the small order to 
trade ahead of the remainder of the customer’s order, thus resulting in the broker’s 
customer receiving an inferior price for the remainder of the order. However, the 
flaw in these examples is that brokers actually route customer orders in a manner 
that ensures that their customers’ orders arrive at various trading platforms at the 
exact same time, so customers receive the best price for their full order. Such rout- 
ing practices are consistent with brokers’ legal requirement to seek the best execu- 
tion reasonably available for their customers’ orders. Specific examples are de- 
scribed in the appendix. 

Additionally, there is growing public interest in a practice called “colocation,” 
which refers to traders locating their data servers in the same physical space as ex- 
changes to facilitate faster trading and profits, which along with proprietary data 
feeds gave rise to latency arbitrage. In general, latency arbitrage entails the ability 
of HFTs to synthesize quotes from all exchanges faster than other market partici- 
pants, thus enabling HFTs to trade on those quotes at a profit. One could argue 
that this activity closes the gap between divergent prices in similar ways as other 
forms of arbitrage. While critics question the “fairness” of allowing certain traders 
to benefit from their physical proximity to an exchange or access to proprietary data 
feeds, proponents of the practice point out that the SEC does not allow exchanges 
to discriminate in offering these services. If an exchange offers proprietary data 
feeds or colocation to any traders, it is required to offer access to all other market 
participants, both HFT firms and non-HFT firms, at the same cost. Under this sys- 
tem, every market participant has an opportunity to colocate. If the exchanges no 
longer offered this access to anyone, either by choice or prohibition, a race would 
ensue to acquire the real estate adjacent to the exchange, which could actually limit 
access to many market participants. One might even view colocation as the modern 
incarnation of market makers vying for position on an exchange floor. Furthermore, 
90 percent of all trades are now executed by colocated traders with access to propri- 
etary data feeds, which includes institutional investors acting on behalf of retail in- 
vestors. 23 

Another issue to consider is the increasing technology “arms race” occurring 
among HFTs. To beat out competitors, HFTs invest more heavily in powerful and 
expensive technology to gain an edge over the competition. But increased competi- 
tion among HFTs may further reduce costs for the rest of the market as HFT mar- 
gins decline. The TABB Group estimates that HFT revenues in the U.S. have 
dropped from $7.2 billion in 2009 to $1.3 billion in 2014. 24 

Much discussion recently has also revolved around the “maker-taker” pricing sys- 
tem that developed roughly 17 years ago, well before the rise of HFTs. 2® On a trad- 
ing platform with “maker-taker” pricing, the liquidity taker pays a fee and the li- 
quidity provider receives a rebate. The first venue to introduce maker-taker pricing 
was Island ECN in 1997. 26 While some have introduced various criticisms of maker- 
taker pricing, this is neither a system nor a problem created by HFTs. The maker- 
taker pricing system can exist in low frequency trading environments and HFT en- 
vironments alike. 

Finally, I note that certain critics of HFTs are also highly critical of the “dark 
pools” where these traders, along with other institutional investors, increasingly 
trade. It is estimated that 15 percent of stocks are now executed in dark pools, 
where information about orders is not publicly displayed. 22 Critics suggest that 
dark trading inhibits the pricing function of secondary markets, and also question 
their opacity more generally. It is important to note, however, that neither dark 
pools nor market fragmentation more generally are “problems” that arose because 
of HFT. The automation of equity trading following the SEC’s adoption of Regula- 
tion National Market System (Reg NMS) in 2005 led to a fragmentation of execution 
venues, including SEC registered exchanges as well as alternative trading venues 
like dark pools. Thus dark pools and fragmentation were partly the result of regula- 


23 Rosenblatt Securities estimate. 

24TABB Forum, “No, Michael Lewis, the U.S. Equities Market Is Not Rigged”, http:! I 
tabforum.com ! opinions I no-michael-lewis-the-us-equities-market-is-not-rigged. 

23 See Larry Harris, “Maker-Taker Pricing Effects on Market Quotations”, Aug. 30, 2013. 

26 Id. 

22 James J. Angel, Lawrence E. Harris, and Chester S. Spatt, “Equity Trading in the 21st 
Century: An Update”, June 21, 2013. 



34 


tion. In addition though, there were general market forces at work. Buy-side traders 
who questioned whether their trades were being front-run on traditional exchanges 
turned to dark pools because of the protection that dark trading brings from poten- 
tial front-running. One key benefit to dark pools is that orders are not displayed, 
thus it is difficult to front-run them or to know when large blocks are being bid and 
offered. Furthermore, it is important to remember that a Reg NMS stock can only 
be traded in the dark if it is executed at a price that is equal to or better than the 
best publicly available price on an exchange. In addition, dark pools are required 
to offer post-trade transparency, as executed stocks are publicly reported in real 
time. While proposals to further reform dark pools, for example, by requiring disclo- 
sure of trading practices or fee structures or imposing antidiscrimination rules, may 
warrant further attention, such reforms are unrelated to HFT and outside the scope 
of my testimony today. 

I would now like to present a few specific proposals that I believe could be helpful 
in ensuring the safety and security of our automated world. 

First, regulators should consider mandating and harmonizing exchange-level kill 
switches. A kill switch is a mechanism that would halt a firm’s trading activity 
when a preestablished exposure threshold has been breached, thus stopping erro- 
neous orders and preventing any further uncontrolled accumulation of positions. For 
example, if a trading firm typically only holds $1,000,000 in shares of NASDAQ- 
traded stock during any point in the trading day, it could be required to implement 
a kill switch at 5 times that exposure-level, or $5,000,000 in shares of NASDAQ- 
traded stocks. If the threshold is breached, further trading would be prevented and 
the firm’s open orders on NASDAQ would be halted. It is important that such kill 
switches be mandatory at the exchange level. This would serve to further mitigate 
volatility related to errant algorithms or “fat finger” errors. 

Second, we might consider addressing the volume of order message traffic, which 
can create market instability, by establishing order-to-trade ratios. Electronic order 
instructions are used to direct the placement, cancellation and correction of orders. 
Since 2005, order flow has increased by 1,000 percent while trade volume has in- 
creased by only 20 percent.^® As was experienced during the 2010 flash crash, a 
spike in orders and cancellations can exacerbate market volatility and overwhelm 
the exchanges’ infrastructure. The current market structure only places costs on 
trade executions, thereby allowing market participants to generate excessive order- 
message traffic without internalizing the costs of the negative externalities just de- 
scribed. Regulators should assess why order volumes have increased and consider 
charging fees for extreme message traffic, keeping in mind that any order-to-trade 
ratios should depend on the liquidity of the stock. 

Third, regulators should consider abolishing immunity that exchanges have from 
liabilities for losses from market disruptions based on their SRO status. For exam- 
ple, NASDAQ received immunity from liability for half-a-billion dollars of losses in- 
curred by brokers from the Facebook trading glitch because it claimed it was acting 
in its SRO, and not its for-profit, capacity. If immunity does not apply to activities 
related to smart routing and other technology offerings, this might better align the 
exchanges’ incentives to limit potentially risky trading activity that could pose wide- 
spread operational risk. 

In addition to the proposals discussed above, I wanted to address two recent sug- 
gestions by Mary Jo White. First, the SEC staff is working to develop a rec- 
ommendation for an antidisruptive trading rule. In theory, such a rule has poten- 
tial as a targeted solution aimed at aggressive short-term traders. However, “the 
devil is in the details.” While such a rule would be aimed at active proprietary trad- 
ers during specific, short time periods when the markets are most vulnerable, basic 
questions will need to be addressed, such as which traders should be restricted, dur- 
ing which time periods, and for which activities. There may be some clear-cut cases, 
where for instance it would be easy to craft a rule that says: “don’t short further 
during a period where stock’s value has declined by x.” But it is perhaps not as 
clear-cut as to whether we should impose an affirmative market-making obligation 
during periods of stress. None of this is to say an antidisruptive trading rule is un- 
desirable; however, it would need to be formulated carefully. 


^^See Gary Cohn, Op-Ed, “The Responsible Way To Rein in Super-Fast Trading”, Wall Street 
Journal, Mar. 20, 2014; and Janies J. Angel, Lawrence E. Harris, and Chester S. Spatt, “Equity 
Trading in the 21st Century: An Update”, June 21, 2013. 

29 See Mary Jo White, Chair, U.S. Sec. and Exch. Comm., “Enhancing Our Equity Market 
Structure”, Speech at Sandler O’Neill & Partners, L.P. Global Exchange and Brokerage Con- 
ference (Jun. 5, 2014). 



35 


White has also asked her staff to propose a recommendation that would subject 
unregistered active proprietary traders to the SEC’s rule as dealers. Again, such 
a rule could potentially be an effective tool in monitoring and regulating the behav- 
ior of harmful trading practices. But it may be difficult to identify which “unregis- 
tered active proprietary traders” should be subject to broker-dealer requirements. 
We have seen similar difficulties in the new practice of designating “swap dealers” 
under Dodd-Frank. Furthermore, a number of these entities may be subject to over- 
sight already. The SEC should ensure that any registration requirements are 
streamlined and coordinated. 

Finally, I’d like to address the topic of decimalization. As I mentioned up front, 
I eagerly await the specifics of the SEC’s pilot pro^am on tick sizes. I would hope 
that the SEC pays particular attention when applying different metrics to different 
types of securities covered by the program, so as not to introduce additional oper- 
ational risk through increasingly complex trading rules for these stocks. For exam- 
ple, I understand the SEC is considering dividing the pilot into three groups of 
stocks, which trade at different increments and may or may not be subject to the 
“trade at” rule. I encourage the SEC to keep in mind the safety and soundness 
of our equity markets when finalizing the design for this pilot. 

Thank you and I look forward to your questions. 

APPENDIX 

The following are specific examples of allegedly predatory trading behavior by 
HFTs from Flash Boys. I follow with a response to the perceived problem posed by 
the example. 

Example 1: On pages 74-75, the example has a customer wishing to purchase 
100,000 shares of XYZ Company at $25 per share. In this example, 100 shares are 
offered on BATS for $25 and 10,000 shares are offered by other sellers on each of 
ten more exchanges. Lewis suggests that the broker’s router will send the buy order 
to BATS first to receive a rebate offered by BATS, even though BATS is only offer- 
ing 100 shares. However, the problem then arises that once the BATS trade is exe- 
cuted, the other 100,000 shares available may disappear before they can be pur- 
chased. 

This example fails to recognize how brokers actually route customer trades in 
order to satisfy their “best execution” requirement, which precedes Reg NMS. In 
practice, brokers will send orders to acquire the 100 shares on BATS and 10,000 
shares on the ten other exchanges at the same time. In fact, brokers have flexibility 
to actually send the order for 100,000 shares of XYZ Company to the other ex- 
changes slightly before they send the 100 share order to BATS, if the broker reason- 
ably believes this will achieve a lower fill price for the customer’s complete order 
for XYZ Company. 

Example 2: On pages 137-138, the example has a customer wishing to purchase 
shares of IBM through a broker (Goldman Sachs in this example). In this example, 
the broker is required to purchase 100 shares on BATS for $19.99 before purchasing 
500 shares on the NYSE for $20.00 due to Reg NMS. As a result, the same problem 
then arises that once the BATS trade is executed, the other 500 shares available 
may disappear before they can be purchased. 

Again, the broker would route the 600 IBM share order to hoth exchanges simul- 
taneously. The broker even has the flexibility to route the 500 share order to the 
NYSE before the 100 share order to BATS, if the broker reasonably believes this 
would achieve a lower fill price for the customer’s order for IBM. 

Example 3: On page 222-223, the example has a customer wishing to purchase 
100,000 shares of P&G through a broker (Bank of America in this example). The 
customer is willing to pay up to $82.97. The broker first pings lEX looking to buy 
100 shares, but then fails to send a larger order subsequently. In this example, 
Lewis suggests that a seller of 100,000 shares at $82.96 could have existed at lEX, 
which the broker missed. Instead the broker pings lEX with multiple 100 share or- 
ders, thus “goosfing] up the price.” 

The flaw with this example is that the broker does not know that there is really 
a “seller waiting on it” for 100,000 shares. Furthermore, if the entire 100,000 share 
order had been sent, and only 1,000 was executed (since the example states that 
there are only 1,000 shares listed), the broker would have revealed the entire size 
of the order, thus dramatically “goosing” up the stock much more than the 100 
share pings. 


30 Id. 

31 A trade-at rule requires brokers and dark pools to route trades to public exchanges, unless 
they can execute the trades at a meaningfully better price than available in a public market. 
It is unclear how the SEC would define a meaningfully better price. 



36 


PREPARED STATEMENT OF JEFFREY M. SOLOMON 

Chief Executive Officer, Cowen and Company, LLC, and Cochair, Equity 
Capital Formation Task Force 

June 18, 2014 

Over the past few years, there has been significant debate about the economic im- 
pact of High Frequency Trading (HFT) on the Equity Capital Markets in the United 
States. Much of this discussion focuses on the specific activities of these market par- 
ticipants and how the rise in their trading activity has introduced increased risk 
and volatility — even within the inner workings of equity market function. In other 
words, memories of the May 2010 “Flash Crash” are still fresh in the minds of mar- 
ket participants and fears of a repeat event are prevalent. 

However, HFT, in and of itself, is not the root cause of increased market risk. In- 
deed, we would argue that the challenges surrounding HFT are actually a symptom 
of a more complex market structure that promotes and encourages potentially coun- 
terproductive trading behavior — behavior that reduces the availability of capital for 
smaller capitalization companies to expand their business and reduces liquidity for 
investors. As such, any debate about the pros and cons of HFT really needs to ad- 
dress the structure of the equity market that has given rise to its existence. 

Today’s market structure has evolved over the past decade and half as a result 
of several regulatory changes regarding trading increments, fair access and order 
routing changes just to name a few. To be clear, each of these changes was well 
intended and has had positive effects on market participants. Yet there are a signifi- 
cant number of market participants who have grown increasingly skeptical that the 
sum total of these changes has actually resulted in a market that is holistically bet- 
ter or worse. 

Rather than debate that point, we are encouraging lawmakers and regulators to 
explore and implement modifications to the current market structure to further im- 
prove equity market function. In doing so, our aim should be to accomplish objec- 
tives that further enhance the capital markets in the United States, which are still 
the best in the world, but are increasingly under siege as other global marketplaces 
evolve. These goals should be clearly defined in their objectives, observable in their 
outcomes, and easily modified as additional data around market performance is 
gathered. 

To be clear, if we remain stagnant in our approach to equity market structure in 
this country, we are increasingly putting our economic growth and private sector job 
creation at risk. Conversely, improvements to the equity market function will not 
only improve the market experience for all participants, but it will continue to foster 
the kind of economic activity that has been the hallmark of the American Experi- 
ence since the outset of the Industrial Revolution. Later in this testimony, we will 
lay out specific observations around market structure that we strongly believe are 
inhibiting capital formation in industries that are vital to the continued economic 
growth of the United States. 

In making assessments about market structure, we have encouraged regulators 
and legislators to be balanced and thoughtful in their approach, while attempting 
to implement change. With just about any market-developed convention, there are 
both positive and negative aspects to the presence of electronically driven trading 
firms that utilize algorithmic-based programs to identify profit opportunities and 
execute upon them. One such positive is that many market participants who engage 
in High Frequency Trading are able to generate profits at very thin trading spreads. 
This attribute has led to a significant reduction in transaction processing and execu- 
tion costs which has translated into lower commissions paid by all market partici- 
pants. 

However, in the quest to accomplish this goal, we have created a highly frag- 
mented marketplace that is quite hostile to the vital functions necessary to promote 
the capital formation that leads to private sector job growth. Not only has there 
been a substantial decline in small company IPOs over the past decade-and-a-half 
(transactions raising $60 million or less), but many small-cap public companies have 
also suffered from a lack of capital formation which has inhibited their ability to 
raise capital efficiently leading to limited job creation, innovation, and investment 
opportunities stemming from startups and small companies. 

For this reason, a group of market participants representing a cross section of the 
startup and small-cap company ecosystem formed the Equity Capital Formation 
(ECF) Task Force to examine the challenges that America’s startups and small-cap 
companies face in raising equity capital in the current public market environment 
and develop recommendations for policy makers that will help such companies gain 
greater access to the capital they need to grow their businesses, create new indus- 



37 


tries, provide increased competition to the markets, and ultimately create private 
sector job growth. 

The attached report from the ECF Task Force, “From the On-ramp to the Free- 
way: Refueling Job Creation and Growth by Reconnecting Investors With Small-Cap 
Companies”, was presented to the United States Treasury in November, 2013, and 
sets out two areas for consideration: (1) the implementation of a pilot program 
aimed at increasing liquidity in small-cap stocks by fostering a simpler, more or- 
derly market structure for trading small-cap stocks and (2) the expansion of access 
to capital for small startups and micro-cap companies by completing the regulatory 
changes outlined in the JOBS Act relative to Regulation A+ and resolve conflicts 
with state laws. These recommendations are designed to enhance capital formation 
for small companies while balancing the needs of investor protection and preserving 
many of the important improvements made to the market structure to which we 
have become accustomed. 

The United States’ one-size-fits-all capital markets ecosystem makes capital for- 
mation for small-cap companies challenging. Today’s market structure is marked by 
speed of execution, lower transaction costs and sub-penny increments, which favors 
liquid, large-cap stocks and inadvertently fosters illiquidity in small-cap stocks 
where the benefits of High Frequency Trading are less obvious. As we discuss in 
the attached report, for many small-cap investors, true price discovery and market 
depth are of greater importance than speed of execution. Indeed, the current market 
structure which favors speed over price discovery is highlighted as a key reason why 
institutional investors, who are the primary providers of capital for small compa- 
nies, have remained on the sidelines — forgoing investment in this critical ecosystem 
because the risk of position illiquidity is too great. 

A well-designed pilot trading program that allows for a true empirical test of the 
effects of wider spreads and limited increments in small-cap stocks will encourage 
fundamental buyers and sellers to meaningfully engage with each other, bringing 
the volume and depth necessary to enhance liquidity in the small-cap market. These 
proposed recommendations would extend to approximately 2 percent of the average 
daily market volume and would certainly be worth the upside of greatly expanded 
economic activity. Importantly, long-term market structure changes in the small-cap 
market will cause other market participants to adjust their trading practices and/ 
or business models accordingly. 

The health of the U.S. capital markets system is critical to driving private sector 
job growth and by extension, America’s future prosperity. As stewards of this system 
and the public interest, policymakers and market participants have a duty to ensure 
that our markets remain fair and orderly, and that their benefits reach the largest 
number of Americans possible. 

We have the opportunity to reexamine the current market structure as it relates 
to small companies and address some of the remaining barriers to accessing growth 
capital to further support the momentum generated by the success of the JOBS Act. 
We can support the growth of America’s most promising private and public growth 
companies by allowing them to access the capital markets to fund their growth, cre- 
ate new industries and provide increased competition to the markets. We owe it to 
those seeking jobs and those small companies creating opportunities to try to adjust 
a small part of the market in order to bring job opportunities to those hard working 
individuals. And we can do it without sacrificing many of the benefits that many 
investors enjoy that were brought about by the advent of the current electronically 
driven market structure. 



38 


From the On-Ramp to the Freeway: 

Refueling Job Creation and Growth by 
Reconnecting Investors with Small-Cap Companies 


Issued by the Equity Capital Formation Task Force 
November 11, 2013 


Presented to the U.S. Department of the Treasury 


39 


Tabu of Contints 


Table of Contents 

I. ExeartiveSommarY--, ^^..1 

II. Statement of Purpose 4 

III. Introduction .,..5 

IV. The Road to the Public Markets 6 

A. The JOBS Act Reopens the On-Ramp - 6 

B. A Surge of Traffic 6 

C. Increased IPO Flow 6 

V. Roadblocks for Startups and EGCs Remain 9 

A. Small Startups Need More Options for Capital Formation 9 

B. Post-IPO, Small<Caps and Investors Need Liquidity for Capita! Formation 11 

VI. Recommendations 12 

A. Improved Access to Capital. Completing the On-Ramp for Promising Small Companies 13 

B. Market Structure: Improving Capital Flow on the Freeway 16 

VII. The Road Ahead ....23 

VIII. Conclusion 24 

IX. Appendices... ....25 


40 


Chart iNOtx 


Chart Index 

Chari A: Total Equity Listings „..5 

Chart B )OBS Act Impact- the Stats - 7 

Chan C‘ JOBS Act Impact — the Stories ™8 

Chart 0: Small'^p Companies and Capital Formation 16 

Chart £: Mutual Funds Snapshot 18 

Chart F. Households Owning Mutual Funds 18 

Chart G; U.S. Equities Ownership & Trading Characteristics 19 

Chart H' Institutional vs. Individual Ownership of All U.S. Listed Stocks 21 


41 


Executivl Summary 


I. Executive Summary 

For generations, the U.S. capital markets have driven America's economic growth and generated millions of 
private sector jobs. l>te sustained success of this vital ecosystem stems largely from its ability - decade after 
decade - to provide an environment where toda/s most promising startup companies can develop into 
tomorrow's global leaders because investors are willing to provide them with the capital to do so. By the late 
2000s. however, the barners to accessing capital for many small emerging growth companies had grown 
signiHcantly - leading to a downturn in the U.S. initial public offering (IPO) market and threatening the long- 
term health of the U.S. economy. 

In 2012, Congress passed The Jumpstart Our Business Startups (JOBS Act) to address the IPO market 
downturn, The JOBS Act aimed to right-size the risks, costs and regulatory burdens that innovative startups 
face in becoming public companies. Impotantly, it did so while preserving important investor protections 
implemented during the prior decade. Less than two years later, it is dear that the XJBS Act has re-energized 
interest in the public markets on the pari of emergir^ growth companies. JUmost immediately, it changed 
how small private companies approach the IPO process, and it has rekindled hope for companies that have 
been delayed or detoured from the public markets by a decade of adverse market conditions. More 
imponantly, the JOBS Act has the potential to reignite interest in innovative technologies and revive the 
viability of business models that, without the prospect of an IPO, entrepreneurs and investors have deemed 
too capital-intensive to succeed. These are the very types of companies that can spawn entire new industries 
- spurring decades of private sector job creation and U.S. economic growth in the process. 

Due to the morrventum generated by the success of the JOBS Act, market participants and policy-makers now 
have the opportunity to address some of the remaining barriers in accessing growth capital faced not only by 
smalt private startups but also by many small capitalization companies that are already piijllc. The process 
of undertaking an IPO and becoming a public company remains expensive. For the smallest companies, the 
five-year window for scaled compliance may dose before the company has built suffident revenue to absorb 
the cost of full public-company compliance. Similarly, publidy traded microops may lack the financial 
resources to undertake the full registration process to raise smaller amounts of capital or even achieve 
listings on a national exchange. Both small startups and miao-caps benefit from greater access to capital, 
but they need a scaled down, more cost-effurient optior) than an IPO. Recognizing this need. Title IV of the 
JOBS Act aims to make Regulation A more aaessible to startups. However, policy-makers have yet to 
complete a number of critical mandates in Title IV, and must make small amendments to the Securities Act of 
1933 to resolve remaining conflicts between new JOBS Aa provisions and state laws. As long as these issues 
remain unresolved, this otherwise low-cost and viable alternative tool for capital formation will remain 
unavailable to promising startupsand micro-cap companies. 

Recommendation #1: 

Expand access to cap’rtal for small startups and micro-caps by completing the JOBS Act's mandates 
regarding R^ulation A and resolving conflicts with state laws. 

1.1 Implement Title IV of the JOBS Act Immediately so that Regulation A-r becomes a viable option for 
small startup and micro-cap capital formation. 

1.2. Amend Section 18(b)(4)(0) of the Securities Act to permit preemption of state securities laws for. 

(a) all securities offered pursuant to Regulation A or Regulation At; or 

(b) securities sold pursuant to Regulation A or Regulation At provided such securities are 
offered or sold through a registered broker dealer. 

1.3. Alternatively or in addition thereto, define "qualified purchaser" under Section lB(b}(4)(0) In a 
manner that would enable small business issuers to rely on preemption of state securities laws for 
Regulation A or Regulation At purposes. 


1 


42 


Execarivt Summary 


1.4. Amend Section 18(b)(4) to clarify that secondary sales of Regulation A and Regulation At 
securities are similarly preempted from state securities laws. 

furthermore, poticy-makers also have the opportunity to mitigate some of the challenges to post-fPO capital 
formation that emerging growth companies and other small*cap companies face. Chief among these 
challenges is an illiqiiid trading market for small-cap stxks. The rise of electronic trading and the regulatiorts 
governing order handling, pricing and execution that followed have created a new market structure for 
equities trading marked by speed of execution and lower transaction costs. While these new dynamics work 
well in highly liquid, large cap stocks, they actually foster opacity and illiquidity in the small-cap market. This 
illiquidity makes it more costly and difficult for investors to invest, trade and make markets (n small-cap 
stocks. Under these conditions, many institutional investors have not scaled their allocations to strategies 
that invest In small capitalization stocks. This development is significant because domestic equity small-cap 
mutual funds, which represent a major segment of institutional investors, hold $409 billion assets* - much of 
it on behalf of U.S. households. Generally speaking, less institutional participation in the small-cap market 
leads to less trading volivne and liquidity for most small-cap stocks, as well as less equity capital to provide 
growth. Absent this liquidity, small-cap companies struggle to attract the type of long-term investors that 
enable them to continue to raise the equity capital they need to sustain job creation and growth after their 
IPOs. The resultant lack of liquidity also harms the largely individual investor base that currently holds the 
majority of ownership in many smalkap stocks by muting the price appreciation they hope to capture 
through long-term investment. Again, this price appreciation cannot happen unless institutions accumulate 
positions and provide liquidity in these stocks. Given these dynamics, the Equity Capital Formation Task 
Force believes that the current market structure is not adequately serving the needs of small-cap companies 
as it relates to their ability to access capital, or the needs of the investors who vrauld benefit from a more 
liquid market in which to buy and sell small-cap stocks. For this reason, the task force recommends 
developing new "rules of the road* for simplifying the trading of small-cap stocks (which the task force calls 
Smali-cap Trading Rules, or STaR,) and testing their effects via a carefully considered, well-designed pilot 
trading program. 

Recommendation #2: 

Encourage increased liquidity In small-cap stocks by fostering a simpler, more orderly market structure for 
smali-cap companies and investors. 

2.1. The national exchanges should conduct a pilot trading prt^ram, overseen by the SEC, in which 
select small-cap companies trade under new Small-Cap Trading Rules (STaR). Under STaR: 

2.1.1 Participating companies will have market capitalizations below $750 million. 

2.1J Partidpating companies should be quoted In minimum price increments of $0.05 and 
trade only at the bid, the offer or the mid-point between the two. 

2.2 The SEC and the national exchanges should begin the process of designing and implementing the 
STaR pilot as soon as is feasible. 

2.3. The STaR pilot design must Include a clear methodology for collecting and analyzing data 
regarding STaR's effects on small-cap trading. Metrics should include (a) relative level of trading 
liquidity, (b) changes in institutional ownership, and (c) rate of equity capital Issuance. 

2.4. The STaR pilot must run long enough to provide a true empirical test of STaR's effects on the 
small-cap market. 

2.5 At the STaR pilot's conclusion, the SEC must use the empirical data generated by the pilot to 


'Mommjitaf. AsBfJune20i3. ^oH-ap" mcludft small wkx, matt blend, smoltgumthfmh 


2 


43 


Executivl Summary 


evaluate whether Small-Cap Trading Rules should apply to smaH-cap trading on a permanent 
basis. 

The Equity Capital Formation Task Force developed the action steps above to be highly specific, targeted and 
limited in application only to startups and small-cap companies. In all. the latter represents only 2 percent of 
trading volume on U.5. equities exchanges.^ 

The health of the U.S. capital markets system is essential to driving critical private sector job growth and by 
extension, America's future prosprity. As stewards of this system and the public Interest, policy-makers 
have a responsibility to ensure that our markets remain fair and orderly, and that their benefits reach the 
largest number of Americans possible. The task force believes that by taking these action steps now, policy- 
makers can help refuel capital formation for America's most promising private and public growth companies. 


"We shou/d never forget why there is a market. We seem to forget that in oli the discussion about 
market structure." — Oyvind 6. Schanke, Norges Bank Investment Management’ 


*Bkicmbeig 

^MpiV/drglbooLnvtimn eorr/20J3/]0/2iVt¥ealifi fund (oution.i ogamst cosu etocteii by higrf sfietd tndinQ/^^raQ 


3 


44 


STATtMtNi OF Purpose 


II, Statement of Purpose 

Comprising professionals from across America's startup and smalKaphalization company ecosystems, the 
Equity Capital Formation (ECF) Task Force formed in June 2013 to 1) examine the challenges that America's 
startups and small^cap companies face In raising equity capital in the current public market environment, and 
2) develop recommendations for polfcy makers that will help such companies gain greater access to the 
capital they need to grow their businesses and generate private sector job growth. The task force’s efforts 
have been informed by discussions flowing from The Securities and Exchange Commission's Oedmallzation 
Roundtable (February 2013), which examined the Impacts of decimalized pricing of securities on IPOs, 
trading, and liquidity for small and middle capltalltation companies-, and from the Capital Access Innovation 
Summit convened by the Treasury Department and the Small Business Administration in June 2013, which 
focused on the impact of the JOBS Act of 2012 on capital formation for emerging growth companies and 
what additional measures might benefn this process This report outlines the Equity Capital Formation Task 
Force's findings and recommendations. 


4 


45 


Introduction 


111. Introduction 

For generations, the U.S. capital markets have been the envy of the world by driving America’s economic 
growth and generating millions of private sector jobs. The sustained success of this system stems largely 
from its ability * decade after decade - to develop today’s most promising startups into tomorrow's global 
leaders. It does so by providing those companies with efficient access to the public capital they need to grow 
and create jobs, and by enabling a wide array of investors to participate directly in that growth through fair 
and orderly markets. Aaording to the Kauffman Foundation, companies that go public increase their 
employment levels by approximately 45 percent after their initial public offerings (IPOs). More significantly, 
for small a)mpanv IPOs, that number more than triples to 1S6 percent.* 

By the late 2000s, however, the challenges that Innovative startups ^ced in getting to the public markets, 
and in realizing the benefits of doing so, had grown significantly. As a result, the number of yearly IPOs 
dropped significantly between 1996 and 2011, as did the number of listed companies on national exchanges 
in the U.S. These developments not only robbed the U.S. economy of a generation of leading companies, but 
led to less capital formation, and, in turn, less job creatioa In fact, the U.S. economy may have created 1.87 
million' fewer private sector jobs over this time period as a result. 


Chart A: Total Equity Listings 



Soiycf Soumer- ftnntfondKnn tdtfoni (uutVorfis. V(MU,JaMV> CfAtnsburte 

The U.S. economy may hove created 1.87 million fewer private sector jobs as a result of the IPO market 
downturn. 


* Pest- IPO CittpJofmtiH ond Ptvtnue Gfowdijor U S. IPO\ June 1996-2010 (Mof 
Tleene/yi/ingtfie/TOMortrt '/OecfmfcefiWZI 


5 


46 


Thl Road lo thi Puauc Marwts 


IV. The Road to the Public Markets 


A. The JOBS Act Reopens the On-Ramp 

In early 2012, lawmakers took action to address the downturn in the IPO market. Working in a bipartisan 
manner, Congress passed the Jumpstart Our Business Startups (JOBS) Act, which President Obama signed 
into law in April 2012. The iOBS Act incorporates a number of innovative measures aimed at reducing the 
burdens and costs that promising startups faced on the path to the public markets. Most importantiv. it 
applied the principle - already in place for a select group of small companies - that regulatory burdens 
should be commensurate with a company's size, and increase as it matto-es, to a new category of oimpanies 
called emerging growth companies (EGCs). This new scaled compliance regime aimed to lower the time and 
cost burdens that CGCs face in preparing to become public companies, and to reduce the risks associated 
with initiating the IPO process. It also aimed to accomplish these objectives while preserving important 
investor protections implemented over the prior decade. 


B. A Surge of Traffic 


Less than two years later, it is dear that the JOBS An has re-energized interest in the public markets on the 
part of emerging growth companies. Since the law's enactment, more than 200 comparties have rostered 
with the SEC as emerging growth companies. That represents 79 percent of aH companies who have filed to 
go public over this tlme.^ As of Oaober 25, 2013. there were 63 companies in registratiwt for an IPO - 
including 48 registered as EGCs. Additionally, Renaissance Capital’s Private Company Watchifst estimates 
that there are 225 IPOs currently in confidential registration or are likely to register soon.^ The taw has also 
rekindled hope for companies that have been delayed or detoured h'om the public markets by a decade of 
adverse market conditiorts. 


79X of companies that hove 
filed to go public since the 
JOBS Act hove registered as 

eacs. 


The JOBS Act has not only renewed interest In IPOs, but has also 
Transformed how startups approach the IPO process while continuing 
their growth. First, thanks to scaled compliance with provisions such as 
SOX 404(b), EGCs can focus their capital on growing their companies and 
creating jobs. Meanwhile, management can focus Its attention on strategy, operations and suaessful 
execution of company business plans. Second, the law’s "test the waters* * provision enables management to 
build relationships with instftinions and research analysts, get feedback on the company's strategy, and 
gauge Interest from investors before committing to an offering. After receiving valuable market feedback 
from public company investors, if company management or its board of directors believes the company isn't 
ready, the company can pull back without penalty, embarrassment or signif^ant cost outlay. Finally, the 
law's confKlential filing provision enables EGCs to begin the IPO filing process while still retaining the ability 
to protect inteitectuai property and other valuable strategic assets from competitors. In the year after the 
JOBS Act was signed, 63 percent of companies that registered with the SEC as EGCs used the confidential 
filling provision.* 


C. Increased IPO Flow 


While the X)BS Act immediately re-energized interest by startups in going public, its impact on the actual 
number of IPOs has been * as many experts expected * more steady than explosive. As of October 25, 2013. 
154 companies had gone public*, versus 121 in all of 2012.^ Similarly, through the same period, 2013 

* Ocotogw onrf ffcnmoncr CapsdI of of Oaober 25. 20J3. 

'iW 

* *Tbe i08S Act Ooe YnrLatfr. A Ae¥iew ef Ore Hern tPQPtoiboak ’ lofftom A AteA 20Xi 

*A» aj IQ/2W20JI 


6 


47 


The. Road to thi Pusuc Markets 


produced 53 micro<ap (less than $250 million market cap) IPO^, versus 32 in all of 2012. In terms of 
percentage of all IPOs, companies with less than $250 million market cap have constituted 34 percent of IPOs 
so far in 2013 - up from 26 percent in 2012.*' 

The fact that the JOBS Act has helped to spur more IPOs has benefitted EGCs and investors alike. Through 
the third quarter of 2013, EGCs had raised a total $26.2 billion in equity capital - capital that can be used to 
advance product development. scaie<up production capacity, build out marketing and distribution 
capabilities, and - most importantly - hire new employees. In addition, the value acaued to public market 
Investors in these IPOs has been signiRcant. The average EGC IPO currently trades at 64 percent above Its 
initial offering price, compared to 30 percent for non-EGCs.*^ 

In addition to its immediate impact on the IPO space, the X)8S Act has the potential to deliver even greater 
benefits to startups, investors and the American public in the future. By restoring the IPO as a credible 
option for EGCs and their investors to raise capital to stay independent, the JOBS Act can reignite interest in 
game<hanging technologies and revive the viability of business models that, without the prospect of an IPO, 
entrepreneurs and investors have deemed too capItaMntensIve to succeed. These are the very types of 
companies that can spawn entire new industries « providing decades of job creation and U.S. economic 
growth In the process. However, such outcomes are far from guaranteed, due to some difficult conditions 
that persist beyond the IPO "on-ramp” and out on the public market. 


Chart B: JOBS Act Impact - the Stats 

On the On^amp: 

63 companies currently in registration with the 5EC.° 

Bstimated Backlog: 

225 estimated companies In confidential registration for an IPO or deemed dose 
to registering for an IPO per Renaissance Capital's Private Company Watchllst. 

Spodred Interest 

More than 200 companies have registered wtth the SEC as emergirtg growth 
companies since the X)8S Act - representing 79% of all companies who have 
filed to go public over this time.'* 

IPO Confidential: 

One year post-JOBS Act, 63% of companies that registered with the SEC as EGCs 
used the confidential filing provision.'^ 

Trending Up: 

Companies witii less than $250 million market caps have constituted 34% of IPOs 
so fer in 2013 — up from 26% in 2012.'* 

Dollan Raised: 

$283 billion In proceeds from EGC companies.” 

Aftermarket Performance: 

EGC IPOs are up average of 64.2% offer/current versus 30.4% for the non-EGC 

IPOs in the comparable period." 


“iw 

** Btoombcty. OntogiL 

^DfolpqKan^HtnttasoneeCaoitalasofOctDber2i. 2013. 

"/W. 

** "The JOfiS Act One Year Lotet : A Arnrw tif ^ New IPO PtoytiOfA . * lutham A Wotft/ns Afiril 20 J 3 . 
^Deahgic 

"Btoomteiy, Oedogk 


7 


48 


The Road to the Pusuc Markets 


Chart C: JOBS Act Impact — the Stories 


Bluebird Bio 
(NASDAQ BLUE) 

Founded 1992 /IPO 2013 

Focus: Innovative gene therapies for 
severe genetic and orphan diseases. 


Lifelock 

(NYSEIOCK) 

Founded 2005 /IPO 2012 

Focus: leading provider of proactive 
identity theft protection services for 
consumers and identity risk 
assessment and fraud protection 
services for enterprises. 


Portola 

(NASOAQ:PTU) 

Founded 2003 /IPO 2013 

Focus: Rghting blood dots and 
bleeding disorders. 


Applied Optoelectronics 
(NASDAQ AAOf) 

Founded 1997 /IPO 2013 

Focus: Advanced optical devices, 
packaged optical components, optical 
subsystems, laser transmitters, and 
Fiber optic transceivers. 


NickLeschly, CEO. 

"Our IPO has enabled us to plan and hire against a more aggressive 
strategic plan. Under the JOBS /4ct the ability ro ^e confidentially 
was incredibly important because It enabled us to keep more 
strategic opt/ons on the table, which is important in the face of the 
uncertainty involved with on IPO. In addition, ti^e ability to 'test the 
waters’ provided us visibility into our potential Investor base, which 
allowed us to make more informed decisions about our strategic 
direction." 

Todd Davis, CEO: 

"UfeLock's decision to go public and raise the capital needed (o 
fnvesf In the technology and people we need to protect Americans 
from ropidly’€volving threats of identity theft was one of our most 
important strategic decisions of the past few years. While the 
process was appropriately rigorous, the greater access to resources 
to ro’lnvest in our business mode it a good choice. We should do 
whatever we can to streamline the process and make the option 
more attractive and easier for companies in the future. * 


Mardi Dier, CFO: 

"Prior to our IPO, we were operating with a thin staff due to the 
uncertain pnancir)g enwronmeni Since then, we have inveosed our 
employee base by 20 percent and we expect to grow even more. 
The 'testing the waters^ provision of the JOBS Act gave us extra time 
with Investors to tell our story, and gave investors extra time to do 
their homework on us. I think that was a key to our IPO's success. * 

James Dunn, CFO: 

"With the capital provided by the IPO. we plan to odd two 
production lines in the US. With that expansion, we expect to drive 
revenue and increase overall production, which will ultimately lead 
to additional jobs being created in the US • specifkolly in fostering 
R&D. Our inggest challenge wr7/ be to understand that this is a long- 
term effort, and that the IPO Is only the beginning of that effort'* 


6 







49 


Roadblocks FOR Startups and EGCS Rcmain 


V. Roadblocks for Startups and EGCs Remain 

A. Small Startups Need More Options for Capital Formation 

Amidst the (PO market downturn of the 2000$, the market segment representing IPOs under $50 mliiion in 
proceeds experienced the steepest decline. Formerly accounting for 80 percent of yearly IPOs”. under-$50 
million IPOs fell to 8 percent since 2012.^ While this segment has witnessed a modest rebound In the wake 
of the JOBS Act, this task Force believes that small startups need more options fer accessing public capital 
thanjustan IPO. 

Even with the On-Ramp provisions, the process of undertaking an IPO and becoming a public company 
remains expertsive. For the smallest companies, the five-year window for scaled compliance may dose 
before the company has built sufficient revenue to meet the costs of full public company compliance. 
Simdariy, small private companies as well as publldy traded miao-caps may lack the finandal resources to 
undertake the full registration process to raise smaller amounts of capital or achieve listing on a national 
exchange. Such companies still need Capital to continue product development, build their marketing and 
distribution capabilities and hire r>ew employees - just not on the scale to justify the extra levels of cost and 
risk that a small IPO or foilow-on offering would incur. However, due to their site and their nsk profiles, 
raising capital from private networks or through debt financing remains difficult for small sianups. For this 
reason, promising small companies need a viable option between these conventional methods and an IPO to 
raise the capital they nevi to grow. 


Who Needs Regulation A+7 


Regulation At could provide small private companies and micro-cap companies with a scaled. 

cost-efficient option for raising puUic capital. Small biotechnology companies provide a 
poignant example: Many have market caps in excess of S2S0 million (because investors value 
these companies based on the present value of future potential earningsl, but can generate very 
little revenue deep into their lives as public companies. This is because their core products can 
remain in the research, development and testing phases for a decade or more. These expensive 
processes, coupled with daily operating expenses and public company regulatory compliance 
costs, can significantly limit the resources these companies can deploy for hiring, product 
development and growth. Providing these companies with more cost-efTicient options for 
raising capital could mean the difference between whether or not a significant medical 
breakthrough ultimately reaches the hands of doctors and patients. 


Title IV of the lOBS Act'' aimed to provide a lower cost alternative to an IPO by raising the offering limits for 
"small public offerings" under Regulation A and delegating authority to the SEC to resolve other issues that 
have limited the use of Regulation A prior to the JOBS Act. These issues Include the costs of disclosure and 
compliance obligations for small companies under Regulation A, relative to the limited offering size, and the 
qualification requirements under state securities laws.” 


®XepfrsefTtiiW)sJ(iimr!SIfciIS97.pnortopieit«iiwTvderlir»*fnofl(et Some' WeiSiOm^ KeoanOL otewom Grout 
raomtofli TheTtoubkmhSmaltTKOSua.^lSetitembeilOUl 

^Deatom 

'’jutrotnortOwlultwitSlivtbtn act, Put]. I No. 112-106, Title tVI2012/ 

^ftuttw/oroa. ContpOofL Jr„ acv(UaIicff>l; imallBuslnc!a'SeoKh/or‘AMoiknneOipilal'.ilDd.l,03ip I 12006): RutheforOO 
Ctimpl)eO,2r,Re^lotiottAanOtheX19SMt AFiiitm!ToReuaeitote,(2012Jtlterem^er, XompteK A Failure to Reouscimte'l 


9 



50 


Roadblocks FOR Startups and EGCs Remain 


So hr, Title IV has not achieved the desired result, as Regulation A remains virtuallv unused.^ The reasons 
for this are two-fold: 1} The SEC has not yet issued the rules mandated in Title IV, and 2) Trtte IV does not 
adequately address one of the key barriers limiting the appeal and utility of Regulation A: preemption of 
state securities laws. As long as these issues remain unresolved, this otherwise low-cost and viable 
alternative tool for capital formation will remain unavailable to promising young startups. 


l/\/Hhout legislation to supplement the JOBS Act Emerging Growth Companies could be left to die on the 
vine, in reach of vital public capital but unable to fully access it" ^Kenneth Moch, CEO, Chimerix, Inc. 


10 


51 


Roadblocks FOR Startups and EGCS Rcmain 


B. PosMPO, Small-Caps and Investors Need Liquidity for Capital Formation 

In the style of the landmark Securities Act of 1933< the JOBS Act focuses on the process by which a company 
enters the public markets. However, while an IPO may be the most important step in an emerging growth 
company's deveiopmem, it s only Day One of that company's life in the public market. Today, many small- 
cap companies are Rndirig life there extremely difficult • not necessarily because of their operating 
performance, but rather due to a number of challenges afflicting the aftermarket support system on which 
newly public companies depend for follow-on capital raises rtecHsary for future growt h. 

Chief among these challenges is an illiquid trading market for smail-cap stocks. In its simplest sense, a liquid 
market is one In which buyers and sellers openly display their price and volume trading expectations in order 
to facilltatethe execution of a stock trade. This type of "efficient'' market balances the broad-based needs of 
issuers, individual investors ar)d their agents. By attracting the broadest base of investors, companies 
achieve a level of liquidity that is commensurate with their site. Absent a liquid market, small-cap companies 
cannot aitraa long-term institutional investors, induding those that administer mutual furtds and pension 
funds, who are necessary to provide the growth capital required by these companies to fund their post -IPO 
growth needs. Long-term investors eschew illiquid markets because they are affected by what Is commonly 
referred to as an "illiquIditY tax." under which the investor materially moves the price of a stock up when 
they aaumulate a position in it. and down when they sell that position. The Illiquidity tax* makes It 
uneconomical for many long-term Institutional Investors to Invest in small-cap stocks relative to larger stocks 
with more trading liquidity. 

For this reason, investors gerwrally value liquid stocks more highly than illiquid stocks. That's imoortam 
because a company's market valuation plays a key role in determining how much equity capital the company 
can raise, and at what cost, in future financing events over Its lif^me. Companies with Nquid stocks that 
have demonstrated they can achieve a fully-valued^ stock price can more easily issue foUow-on offerings, or 
use their stock as currency to fund acquisitions, compensate employees and compete for talent. By contrast, 
those public companies with a poor trading liquidity profile are sometimes unable to raise additional capital 
through the public markets, or can only do so at a higher cost of capital.^ This dynamic can constrain their 
growth and, In many cases, can defeat the purpose of going public in the first place. 

UnfortunatelY, over the past decade and a half, hundreds of companies have learned this lesson the hard 
way. As a result, secondary market trading liquidity in the small-cap market has become a serious 
consideration for any company when it weighs the risks and costs of going public versus other finanang 
alternatives or exit strategies. As long as the view from the IPO "on-ramp" suggests that the prospect of 
taking on all of the additional costs and risks of goir^ public, but struggling to capture the beneBts. many 
startup founders, managers and investors will continue to think twice about (loosing to finance their growth 
via the public market. 


AwfingMmtme/iCs. *Aaolf:lngihgAnolytU: ASwvevofOKStmrofWoUStrtnEifVKyKtieprcfilOfnnafttrthe 
(Hobalie<nf»Knt*IJenMrf20Ui SeMd&tpnet’Oi-iQieifMc 

’'m 


11 


52 


Recomucndations 


VI. Recommendations 

As discussed in prior sections, tne success of the X}BS Ad has created an opportunity for market partidpants 
and policy-makers to remove additional barriers to capital Formation for private startups, EGCs and small<ap 
companies. In order to improve access to capital for additional small startups and mlcro^aps, we must give 
these companies more cost-effedive options for accessing investor capital. In order to move more promising 
small companies from the '‘on-ramp” to the "freeway,” as well as improve capital formation for liquidity' 
challenged small-caps, we will need to inaease trading liquidity for small-cap companies and the investors 
who want to invest in them. Doing so will require adion by policv-makers and market partidpants on two 
fronts: 

Improved Access to Capital: Completii^ the On-Ramp for Promising Small Companies 

While the )OBS Ad has re-opened the on-ramp to the public markets for many promising startups, small 
companies for which an IPO may not be cost effective remain in need of alternative options for accessing 
public capital. Title IV of the JOBS Ad recognizes this need by calling for modifications to Regulation A. 
However, those modifications have not yet been made • leaving many promising small startups and mkro- 
cap companies with the same capital formation challenges they faced prior to the JOBS Act. 

Recommendation ftl: 

Expand access to capital for small startups and micro-caps by completing the JOBS Act’s mandates 
regarding Regulation A and resolving conflicts with state laws. 


Market Structure: Improving Capital Flow on the Freeway 

The current market structure is not serving the needs of small-cap companies or the investors who wish to 
buy and s^l their stocks. Specifically, quote irKrements of $0.01 and the ability to trade In between pennies 
at fladions of one cent make it difficult for fundamental investors to firxl adequate trading liquidity in which 
they can accumulate or exit meaningful investment positions in small-cap stocks. As a result, many 
institutional investors - including those who invest an estimated $409 billion in small-cap US equities 
through mutual funds^ * have found it more difficult to invest in small-caps. The resulting tack of liquidity 
makes it even more difficuit for these companies to raise capital beyond their IPOs to fund hiring, produd 
development and expansion of their marketing and distribution capabilities. 

Recommendation tfZ: 

Encourage increased liquidity in small-cap stocks by fostering a simpler, more orderly market structure for 
small-cap companies and Investors. 


These challenges and recommendations are examined In depth in the following pages. 


^Mbnwnsprgr AtefJuneiOil ’^oHKQp’tntMnsmoKvotue.tmuUblend.imttfnwtlffwftli 


12 


53 


Recommcnpations 

A. Improved Access to Capital: Completing the On-Ramp for Promising Small Companies 

Recominendation 

CKpand access to capital for small startups and micro-caps by completing the JOBS Act's mandates 
regarding Regulation A and resolving conflicts with state laws. 


Prior to the JOBS Act, small companies looking for a more cost-efReient optiort far raising investor capital 
than an IPO were limited to phvate placements, a S06(c) offering under Regulation 0, or an offering under 
Regulation A. By design, each option has its limits. In the first two cases, the trading in the resulting security 
is restriaed, and as such, provides less liquidity to investors (the implications of which are described on page 
ll.| By contrast, a Regulation A offering results In a security that can be traded pubikly, but Regulation A has 
gone virtually unused by startups and micro-caps. 

Regulation A provides an exemption for offerings up to only $S million for issuers who are not subject to the 
reporting requirements of section 13 or lS(d| of the Securities Exchange Act of 1934 (the ‘txchange Act") 
immediately prior to the offering.^^ The Regulation A exemption is subject to the filing of a Form l-A with 
specified disclosure requirements, allows widespread solicitation, does not require purchaser qualiheations 
and allows unlimited resale of secuhties purchased pursuant to Regulation A. The reasorts for the relative 
noH'Usage of Regulation A include the costs of disclosure and compliance obligations relative to the limited 
offering size (notwithstanding that the disclosure requirements are less than those required by Form S-1) and 
the often costly and burdensome qualification requirements under state securities laws.'^ 

Title iV of the JOBS Act delegates to the SEC the authority to enact regulations to address the issues that have 
effectively rerviered Regulation A non-viable as an alternative for efficient, broad-based capital formation for 
small businesses. Specifically, Trtle IV added a new section 3(b)(2} to Section 3(b) of the Securities Act of 
1933 (the "Securities Act"), which requires the SEC to enact a new regulation to exempt offerings of up to 
$S0 million in any 12-month period from registration. Additionally, section 3(bK2) requires that: 

(a) such exemption be conditioned upon an issuer filing annual audited financial statements.^ 

(b) the securities shall not be restricted securities; 

(c) that section 12(a)(2) civil liabilities will apply; 

(d) the securities may be offered and sold publldy; and 

(e) the issuer may solicit interest in the offering prior to the filing of any offering, on such terms and 
conditions that the SEC may presaibe in the public interest or for the protection of investors.* * 

Further, new section 3(b)(2) provides that the SEC may enact other requirements it deems necessary in the 
pubik interest artd for protection of investors, which may inctude requiring investors to file an offering 
statement, as well as ongoing periodk disclosures, with the SEC and prohibiting "bad actors" from availing 
themselves of the new exemption. last, and perhaps most signiheantiy. Title iV amends Section lB(b)(4) of 
the Securities Act to exempt offerings made pursuant to new section 3(b)(2}, provided the securities are 
offered and sold on a national exchange or offered or sold to a qualified purchaser, as defined by the SEC. In 


"tSM(!rsfmrUsbote(/.5 uCotyodiantUuenaiHlmafnalbe: odififviopmtntitogttomponYmitiiaaspa^ictmtnesspkifforpurpiiiie 
or flat irdKOted phn u to met^e mtft uaktent^ieri nnnpony. on mtiatment empanf. an en^tv <nuin 9 ^^wnol wpOiWiM mtrrejO «r 
(N(or9O!ri9rioar5ifTFi/ariiMrrvits«ioUM’rmMenirni9hciorc(b9oo/VfetfonUrf]ircO0Oi67 fte^ulotion A. }7 C.f .H ii2302iJ J63 

*aotfM/orUa. CompteAAv At'eufcKrtmA: 5maHBiiiimss'Si!orthfar'AMoikntrCapttor.i1Dri.J Carp i i2006); Autttfford B 
Compbe^lr^ Regulation A OH^thfiOSS Act: AFoUunTeHeoadtate, {20J2Hf>rrriooftef. TompbaV, A foAm (o flciftticJrotf 

^CvfrfnUy under erjdooion A, tuumorr rvgutftd ee pnmleflnanemlstatmenis but itxR fmonaoi mumeonnettlnGitie ouihM 
i77tbH2DW 

"fWd, 


13 


54 


Recommcndations 


other words, state securities laws would be preempted for offerings made under section 3(b)(2) as those 
securities would be 'covered securities”, but only if such securities are traded on a rtaiional exchar^e or are 
offered or sold to a qualified purchaser. 

However, Tftie IV does not appear to have had. and likely will rtot have, any measurable impact on the use of 
Regulation A as a means for small businesses to access capital. The reasons for the relative nonosage of 
Regulation A include the costs of disclosure and compliance obligations relative to the limited offering site 
(notwithstanding that the disclosure requirements are less than those required by Form S^l) and the often 
costly and burdensome qualificatfon requirements under state securities laws. 

Absent the enactment of the mandatory or discretionary provisions of Tide iV, issuers are limited to current 
Regulation A, which has been relatively unused. Second, absent dahRcation or amendment, one of the 
barriers to more widespread appeal and udiity of Regulation A, namely preemption of state securities laws, 
remains a significant obstacle under Title IV. SpeciRcally, although Title IV provides that state securities laws 
will be preempted for section 3(b)(2) offerings, this preemption is predicated on the securities being traded 
on a national exchange or offered or sold to a qualified purchaser. With respect to the former, most small 
businesses are not likely to have their securities traded on a national exchange and. If required to do so, 
would incur additional burdensome compliance costs associated therewith. With respect to the latter, until 
the term "qualified purchaser' is defined, small business Issuers are unable to rely on that provision for 
preemption purposes. Accordingly, section 18(bKA)(0) in its current form does not adequately resolve the 
issue of preemption of state securities laws. It would seem incongruous to deem securities sold through 
Regulation to be freely tradable at the federal level but to remain restricted at the state level, yet that 
remains the case. Absent resolutiort of the preemption issue, small business issuers will need to artafyze and 
comply with the securities laws of the various and multiple jurisdictions in which it may offer or sell securities 
under Regulation A, as amended under Tide IV or otherwise. In addition to the signihcant costs associated 
with such compliance, it is not clear that compliance with an applicable exemption under stale securities 
laws would permit issuers to take advantage of some of the intended beneKts of Title IV and seaion 3(b)(2), 
including 'testing the waters' or general solidtatlon provisions of section 3(b)(2). 


Detailed Recommendations: 

1.1 Implement Title iV of the JOBS Act Immediately so that Regulation A* becomes a viable option for 
small startup and micrtxap capital formation. 

1.2 Amend Section 18(b)(4)(D) of the Securities Act to permit preemption of state securities laws for: 

(a) all securities offered pursuant to Regulation A or Regulation or 

(b) securities sold pursuant to Regulation A or Regulation Ai provided such securities are 
offered or sold through a registered broker dealer. 

1.3 AKemativelY or in addition thereto, define 'qualified purchaser' under Section 18(b)(4)(D) in a 
manner that would enable small business issuers to rely on preemption of state securities laws for 
Relation A or Regulation At purposes. 

1.4 Amend Section 18(b)(4) to clarify that secondary sales of Regulation A and Regulation A^^ 
securities are similarly preempted from state securities laws. 


Analysis: 

Making "Regulation a reality for small startups and micro-caps will provide these companies with a 
number of cntical berwfits in their efforts to raise capital to grow and create jobs In the private sector. It will 
provide them with a lower cost, less burdensome process for raising public capital - a scaled r^istratlon. so 


14 


55 


Recommcndations 


to speak. Although the process involves less rigor than a full registration, there is a level of due diligence and 
disclosure involved In a Regulation A+ offering that mitigates some of that risk for potential Investors. In 
addition, this process provides early exposure and relationship-building opportunities for offering companies 
with an investor pool that trades in micro-cap stocks. Similarly, a full Regulation A+ process enables startups 
and micro-caps to use important JOBS Act options such as "test the waters* and "ger>eral soliotation.* Going 
forward, the Regulation A*^ process results in a security that can be traded publicly, which provides more 
trading liquidity than other options such as a private placement or S06(c) offering. Finally, the entire process 
provides an invaluable primer for the full r^stration process, should a company's growth make a foltow-on 
issue Of listing on a national exchange viable options. 

The foregoing recommendations, coupled with implementation of ongoing periodic disclosure requirements 
which are reasonable in srope, balance Investor protection concerns with regulatory and compliance costs, 
and will provide small businesses with a truly viable alternative for efficient, broad-based capital formation. 


IS 


56 


Recommendations 


B. Market Structure: Improving Capital Flow on the Freeway 

Recofninendation #2: 

Encourage Increased liquidity In smatl-cap stocks by fostering a simpler, more orderly market struaurc for 
small-cap companies and Investors. 


Quite a few market observers have chronicled the changes that have occurred in the U5. equities markets 
since the mid'1990s. Many have reached a similar conclusion: The rise of electronic trading and the 
regulations governing order handling, pricing and execution that followed have created a new market 
structure for equities trading marked by faster execution speeds and lower transaction costs. By 2010. rt was 
estimated that electronic trading accounted for more than 70 percent of equity trades taking place in the 
U.S.*’ These developments have produced a new generation of algorithm-based trading strategies that focus 
on high-voiume, large-cap stocks and often prioritize speed of execution over price of execution. 

Within this new market structure, the economics of large-cap trading remain reiativety healthy, as the 
combination of k>w transaction costs, low trading commissions and high volume provides sufficient incentive 
for market makers to create active markets for these slocks. For this reason, the ECf Task Force is not 
tecommendlna changes to trading practices for large-cap stocks. However, while narrower spreads and 
lower transaction costs have benefitted many investors, they are not the only meaningful metrics kir 
measurirtg the health of the overall market ecosystem. Nor do they come without tradeoffs and costs of 
their own. So far, analysis on the part of many academics and market observers overwhelmingly suggests 
that these costs are being borne disproportionately by smalkap companies and fundamentals-based 
investors - both rnstitiitronal and individual — who want to buy, sell or hold small-cap stocks as part of a 
long-term investment strategy. 

From the small rampany perspective, the new market economics have put significant strain on the 
aftermarket support system kjr small<ap stocks. This effect goes beyond merely suppressing the number of 
IPOs over the last decade and a half, it's a structural issue, as the entire support system of small investment 
banks, institutional sales desks, market makers and research analysts has been decimated by the new market 
economics, With less support for life after their IPOs, fewer staaups may see the public markets as offering 
the best option m their quest to evolve into large, enduring Institutions. In short, they may turn away from 
the IPO ‘‘on-ramp" - whether It’s “open" or not. 

Chart D; Small-Cap Companies and Capital Formation 


Before 1997 After 2001 % change 


Tick sizes 

$0.25 p«r share 

$0.01 per share 

-96X 

investment banks (acting as a bookrunner) 

167(1994) 

39(2006) 

-77% 

Small company IPOs 

2,990(1991-1997) 

233 (2001-2007) 

-92% 


SowtT' Wtitd. DarttH, mtl> £ lUmonOL <Vcwpt;rt Oninl TXornton, 'Tht Troublv wHhSirHiU TnkSt^y* {ieptrmberlOIJt 


For institutional investors, the new market structure has made it more difficult and costly to trade, invest in 
and make markets in small-cap stocks, that’s because many of the new trading strategies -driven by faster 
execution speeds, lower transaction costs and sub-penny increments - that have proved so effective in large- 
cap trading actually foster opacity and llliquiditv In smail-cap tradir^. The following provides an example of 
this dynamic at work- 


Tbmii Trading MtoJ/tk)g.d)emistn(kng.cwn/te tfiionesi/ 


16 


57 


Recommendations 


Suppose an institution were to post an offer to sell a lot of 1,000 shares of a small<ap stock at the price of 
$5.00. Under the current trading regime, another market participant can quickly "step In front* * ** of that order 
at virtually no cost by offering to sell shares in the same company at a price that can be as little as 1/10 of a 
penny lower than the $5.00 ask. Moreover, the trader who Is “stepping in front* can execute the trade off- 
exchange with an incoming order from one of his customers, thereby precluding the original price setter 
from having its original advertised trade executed. 

"The US market has gone through a lot of changes and has become quite complicated ^ and tNs 
complexity of the market creates a lot of challenges for a large investor kite us." — Oyvind G. Schanke, 
Norges dank Investment Management, which holds $110 billion in Ui. stocks.” 

To defend against the scenario above, many institutional investors and traders now break their large blocks 
into many series of smaller lots in order to appear to the market as small retail orders. This praaice adds 
extra time and costs to the process of accumulating or exiting significant positions in smalkap stocks. In 
fact, one estimate puts the costs to the overall market of “stepping in front* of orders at five to 10 times that 
of any other cost.^ Worse, this practice reduces liquidity in the market for these stocks. In fact, the 
combination of low liquidity and higher risk in the form of single-stock volatility has prompted many 
Institutions to underinvest in the small-cap market. This is significant for two reasons: 

■ First, research points to a positive correlation between higher levels of institutional ownership and 
more liquidity and higher company valuations.” On the other hand, lower levels of institutional 
owrtership correlate to less liquidity and lower valuations. As outlined on page II. this lack of 
liquidity can lead to lower valuations and constrain a company's ability to raise capital. In turn, this 
makes it more difficutt to hire more employees, invest in research and development, and inaease the 
overall scale and scope of its enterprise. In this sense, small companies once again bear the brunt of 
the new market structure's cost, 

■ Second, the costs and effects of small-cap market trading dynamics on institutional investment 
strategies are not limited to the institutions themselves. That's because individual investors are 
increasingly participating in the equities markets through mutual funds [see Chart F], most of which 
are managed by insitutions. For many Americans, mutual funds are the only dtoices offered through 
their employer-provided retirement plans. In fact, according to a recent survey by the ICI, 93 percent 
of mutual fund owners invest In such funds in order to build their retirement funds.” Domestic 
equity smali-cap mutual funds now hold $409 billion in assets'^ • much of it on behalf of Ui. 
households. For these reasons, the traditional distinction between institutional and individual 
investors • and what market dynamics benefit one or the other - has become increasingly difficult to 
draw dearly. What is dear is that institutional participation In the small-cap market affects millions 
of individual investors who access the equities market through no other investment vehicle, 
increasing this partidpation on the part of individual investors could connect billions of 3ddltior>al 
investment dollars from average Americans with the emerging growth companies that need those 
dollars most for capital expansion • and that offer the greatest potential for long-term growth. 


** httfi://liealbootnytimn.mn/SOW1O/2O/0>eakh fttna m/tiem-ogo'M^ota aotttd by hi^ipfHi-tnimy/^^r=0 

'AnWyii/vUwA/NVytO: A Survey t^tXe State ofWoMStnttlquityXafnnX 10 Vtea offer tfit 

StBboi SetOmM* Ifatiiory 30ii} 

* Company mattutt 2Qi3 

**Mcmiogitar AstifJune20ii. ImoH cop’ mrMessmoX value, sinaitbletiii,smatt 9 nwthfunei 


17 


58 


Recommendations 


Chart E: Mutual Funds Snapshot 


U.S. Mutual Fund Assets; 

5l3 trillion at year^end 2012" 

Percentage of Mutual Funds Assets Ouvned by Households: 

89%" 

Percentage of Mutual Funds in Equities: 

45%“ 

Assets Held by Equity Small-Cap Mutual Funds: 

5409 billion'' 


Soiine.MafningistOfiht/fstwefitCompoityltistitute 20J3 


Chart F; Households Owning Mutual Funds 


(mtiona of US HcustMOa) 
60 


50 * * ** 

40 

30 

20 

10 

0 


48.6 


50.3 


(Ptrant cf US NousaAoMrJ 
- 100 % 

53.2 S2.9 53.8 , 


60 



4.6 


1980 1985 1990 1995 2000 2005 2010 20U 2012 


40 


20 


Soared. Mvertmem Catnpwiy 20 13 


Of course, millions of individual investors also participate directly in the equities market without institutional 
products like mutual funds or pensions. Some argue that these investors are the primary beneficiaries of the 
current market structure due to the lower transaction costs they now enjoy. However, the task force 
believes that this argument misses the bigger picture. According to CaplQ, retail investors own nearly 75 
percent of all small-cap company'^ shares In the market. By and large, these investors own small-cap stocks 
because they aim to realize price appredation over the long term as those companies grow. Unfortunaiety, 
for most smalkaps. that price appreciation will be muted without the liquidity that only comes from robust 
institutional participation in the market For this reason, the ECF Task Force believes that a more liquid 


•/wd 

* fmrtstmfnt Company kntitute. 2013 

‘*MomingitoT Aiofiurte2Qi3. *imoHaip’mdu(lei\maUyQlui;,smaObleod,smolisfowtfffundi- 

* 2013 Company fact Book: A Aewew of Tmd» ani thelrmstmti^ Company Mdustry- Wcshrnjton PC: 

Mwiimcnr CoffipoFiy Artyifurp 4wgitefaif at tUooi.cia<WR:J/nniN Aifocibcok oia . 

** Pf/herf 05 cpmparHM witfi market covu unpet $250 milkon. 


18 










59 


Recommendations 


smalkap market with greater participation by institutions will offer greater potential benefits to individual 
investors over the long term than price improvement on their trades. 

Chart G: U.S. Equities Ownership & Trading Characteristics 


Sub $7S0 Market Cap 

Above $750 Market Cap 

Institutional Ownership 

31.314 

83.3»i 

Retail Ownership 

6S.8K 

16.7% 

Research Analysts 

2 

14 

30OAO1V 

0.3 million shares 

18 million shares 

30OSAOTV 

$2.0 million 

$70,0 million 


iowa. CopfQ os 0 ) OtUKcr 25, 20li /ncMrs o*i mqlar (/.5 tffdntttyei. 


Given the dynamics outlined above, the Equity Capital Formation Task Ftyce believes that the current market 
structure Is not adequately serving the needs of small<ap companies or the Investors who wish to buy and 
sell their stocks, For this reason, this task force recommends developing and implementing new "rules of the 
road" for the trading of small-cap stocks. Speafically, public companies with market capitalizations of below 
$750 million should be quoted at minimum incremertts of five cents, and that they should trade at only the 
bid price, the ask price, or the mid-point between the two. The task force believes that these Small-cap 
Trading Rules (STaR) will foster a market structure for small-cap stocks that will provide for fundamental 
trading liquidity in these issues. 

Unfortunatelv. there exists no method for testing or studying STaR's potential effects outside of the 
implementation of a program that can observe live trading over a significant period of time. Therefore, these 
rules should be implemented as part of a carefully considered, well-designed pilot trading program that limits 
its impact to smail-cap stocks, tests the effects of STaR empirically over a significant time period, and enables 
the SEC to determine whether STaR should be implemented permanently for small-cap trading. 


Detailed Recommendations: 

Z.l. The national ejichanges should conduct a pilot trading program, overseen by the SEC, in which select 
small-cap companies trade under new Small-Cap Trading Rules (STaR]. Under STaR: 

2.1.1. Participating companies will have market capitalizations below $750 million. The $7S0 
million market cap criterion was selected by the task force to focus the benefrts of STaR on 
only those companies that need them, without Impacting market structure for the vast 
majority of the market. According to our research, a cap of $750 million will limit STaR's 
effects to only 2 percent of ail trading volume on U.S. enchanges.^ 

Z.1J. Participating companies should be quoted In minimum price increments of $O.OS and trade 
only at the bid, the offer or the mid-point between the two. Most of the analysis of current 
market structure has zeroed in on increasing minimum quote increments as the best option for 
mitigating the effects of the new market structure on the IPO and small-cap ecosystems This 
theory posits that larger spreads wHI induce liquidity In small-caps, which in turn may 
eventually restore incentives for traditional aftermarket support. While this task force agrees 
with that assessment, its members also believe that widening minimum quote inaements 
alone Is not enough to affect all of the trading practices that currently inhibit smalkap 
liquidity. 


‘‘flloomArig 


19 


60 


Recommcndations 


for this reason, the task force has indiided the trading stipulations ootlined above. Under 
STaR. both institutiorei and individual investors can be matched at the increment. Institutions 
that internalite order flow will still be able to provide price improvement for individual 
investors, but oniv at the mid-poini between the bid and offer. By limiting the number of 
Inaemenu at which a small-cap stak can trade to the bid price, the offer price or the mid- 
point between the twa STaR will eliminate sub-permy increments and aeate fewer total 
points at which a market participant with a customer order In hand can "step in front' of an 
order > thus redudr>g the incidence of this practice. In turn, this will encourage fundamental 
institutional investors and fundamental market makers to post more liquictty on their bids and 
offers. 

2.2. The SEC and the national exchanges should begin the process of designing and implementing the 
STaR pilot as soon as is feasible As mandated by the JOBS Act, the SEC studied and reported on the 
impac of smaller spreads and dedmalizaiion Icollectively referred to as "tkk sizes") on capital 
formation. However, after Its review of academic literature, the SECs report to Congress in July 2012 
stated that further study was required to acquire the requisite data to draw a conduston. During and 
since that time, the SEC has engaged in dialogue with the national exchanges on the possibility of 
developing an alternative market structure for small-cap trading. The Equity Capital Formation Task 
Force understands that this dalogue is ongoing, but this task force also believes that the time for taking 
aaion is now. That is because for each day that the U.S. smalkap ecosystem underperforms, 
Americans potentially lose innovative products and services, tax revenue ar>d new jobs. Ultimately, the 
SEC must act as the final arbiter of the planning and implementation process, in this role, however, 
they must solicrt and weigh input from all stakeholders In this process, as well as consider all relevant 
research and data that may Inform the implementation plan. 

2.3. The STaR pilot design must include a clear methodology for collecting and analyzing data regarding 
STaR's effects on small-cap trading. This methodologv should measure the eftos of STaR through 
analysts of the followir^ metrics' 

(a) Relative level of trading liquidity. Relative level of trading liquidity will be measured by any 
changes in the number of blocks traded (more than 5,000 shares), number of trades (absolute), 
displayed liquidity (quote) size, Average Daily Trading Volume, and slngJe^me stock volaillity. 

(b) Changes In Institutional ownership. Increases In institutional ownership would be desirable, both 
in number of institutions and as a percentage of ownership, because Institutions generally provide 
higher trading volume. 

(c| Rate of equtty capital issuance. Higher rates of equity capital issuance would be a marker for 
lower costs of capital because issuers would resist issuing equtty capital at depressed prices. 

2.4. The STaR pHot must run long enough to provide a true empirical test of STaR's effects on the small- 
cap market. Under the pilot. STaR must remain In effect enough to allow for meaningful data capture 
and analysis across multiple business cycles and market environments. STaR must also remain in efTec 
long enough to allow or encourage market participants to adjust their trading practices and/or business 
models to address potentially long-term market changes engendered by STaR. Otherwise, market 
participants may see less risk in simply "waiting out" the pilot, as opposed to changing their practices to 
capture or defend against resulting market effects. 

2.5. At the STaR pilot's conclusion, the SEC must use the empirical data generated by the pilot to evaluate 
whether Small-Cap Trading Rules should apply to small-cap trading on a permanent basis. 

Ano/ysis 

While the factors and market dynamics behind the changes in the U.S. equities market are complex, the 

underlying economic imperative is relatively simple. If we want investors to assume the risks and extra costs 

inherent in trading small-cap stocks, market structure must provide the potential for profit in doing so. The 


20 


61 


Recommcndations 


Equity Capital Formation Task Force believes that larger minimum quote inaement sizes and fewer price 
increments at which to trade will help produce this outcome. That's because the combination of these two 
important changes will allow for a simpler, more efficient market by enabling fundamentally oriented 
investors to more comfortably Increase the posted she of their bids and offers while having to defend 
themselves less often against the practice of "steppli^ in front" by other market participants. Price 
improvement will still take place for a number of reasons, but It will do so at fewer and wider (naements. As 
a result, the task force believes that these changes will encourage greater liquidity in small* *cap stocks for 
investors. 

Over time, the return of liquidity to the smatkap market may lead to a recovery of the aftermarket support 
system for small*cap stocks. With some of the economic incentives for small-cap trading restored, 
institutions may begin to invest resources in rebuilding their market*making and research functions. 
Research is a critical component of the information investors need to discover stocks, make informed 
investment decisions, and achieve positive outcomes. Yet, research can be scarce in today's market 
environment. In fact, nearly 29 percent of all exchange^isted companies have no "meaningfur analyst 
coverage of their stocks.^ Among companies with market caps of less than $250 million, 55 percent lack 
meaningful coverage Put another way, investors cannot access meaningful analyst research on more than 
half of all micro*cap stocks. 

For companies without meaningful analyst coverage, the consequences for long-term capital formation are 
significant. There is a causal relationship between high-quality analyst coverage and a stock that Is widely 
held, actively traded and fully valued. Correspondingly, the absence of coverage can lead to low visiblirty 
among investors, limited liquidity and lower market valuation relative to peers.^^ This also results in higher 
illiqutdity taxes paid by the individual Investors who overwhelmingly own their stocks. 


Chart H: Institutional vs. Individual Ownership of All U.S. Listed Stocks 

Mkt Cap Range 


Median 


Market Cap 

Institutional Ownership 

Individual Ownership 

S0M-50M 

S27.4 

10.714 

893% 

SSIM-IOOM 

7L7 

19.5 

80.5 

S101M-250M 

17t7 

35.8 

64.2 

52StM-500M 

548.4 

49.3 

50.7 

S500M-1BN 

7118 

70.D 

30,0 

SlBN* 

3,448.3 

84.0 

16.0 


Sounv: OOta fnm CaptQ: mfihoacicgtf ay Xfoting trmfpnmts 


In conclusion, the Equity Capital Formation Task Force believes that the combination of wider quoting 
inaements and limited executnn prices provided by STaR will bring back the fundamental institutional 
investors necessary to provide additional trading liquiditv to smalkap stocks - arnl the positive equity capital 
formation that accompanies it. It must be noted that this task force does not make recommendations for 
changing market practices lightly. Nor is it suggesting that the market structure be changed for trading in 


'*X«(ninA firn ITeotfng Irwertmcnu. MnoVr^njrrtwAnotyiu; ASunty^tfiheStotro/WaUUrtnE^iKyMe^eortblOYeont^^rrihe 
Giabal Settlement * {January 20i3{ l^eoMngful’ Is dejinetl os hating at least one endyitfram tftf tOOffrmi /ndMfctf on 

enfier the tr&tJtuOonal Imestai orStorMine tut of anolysi ronkingx 

*X«atN>aTIm Among *Aaoly:ing {Im Andy sts: A Survey of 0>e State o/ Wot itteetBouayHeiearth JO Yeofst^r Ore 

GJobal SetOemeni * {January XW 

"m 


21 


62 


Recommcndations 


larBer companies, where the bulk of the positive effects of dedmallzatlon are most prevalent. Again, the 
small companies that would be affected by STaR account for only 2 percent of all trading volume on U.S. 
exchanges.* 


5moD cop !toda account for 
only 2% of trading volume 
on US exchanges. 


That may seem like a small segment of the market on which to focus, but 
it Is from where tomorrow's leading US companies will grow. For this 
reason, market participants and poUcy-makers must seize this 
opportunity to nurture this chtical ecosystem. Critics may argue that the 
need for such nurturing proves that many of these companies do not belong in the public market. Such an 
argument is shon-sighted and unfair. Every smalkap company should have the opportunity to succeed or 
fail based on its fundamental performance and the willingness of long-term investors to provide It with 
capital for growth - not because the mechanics of how stocks are bought and sold today, versus 20 years 
ago, has changed. STaR will help restore that opportunity. 


^Sloombfrg 


22 


63 


Th£ RoadAhlao 


VII. The Road Ahead 

Amerka's capital markets work because they are fluid, dynamic, innovative and responsive. As stewards of 
these markets, we must embrace these same traits in our management of them. By acknowledging the 
issues outlined in the preceding sections, and by taking the recommended actions, this task force believes 
that market stakeholders will fulfill that responsibility. However, we must also see the bigger picture, and 
anticipate those roadblocks that lie beyond those we currently undertake to remove. 

Irt this context, the Equity Capital Formation Task Force has identified two additional facets of the Ui. capital 
markets ecosystem that market participants and policy-makers will need to address in the wake of this 
report. These concern equities market research, and the regulatory landscape that emerging growth 
companies and other smalkap companies face - from the day they are founded to their daily operations in 
the public markets. 

As described in the preceding market structure section, analyst research is a critical component of the 
information investors need to discover stocks, make informed investment decisions, and achieve positive 
outcomes. Yet the amount of research published by regulated, accredited research analysts and available to 
investors regarding many smalkap companies is insufficient for supporting requisite trading liquidity in 
those stocks. Recognizing the important role that equity research plays In the IFO process, the X)BS Act 
sought to address some of the limitations surrounding equity research for newly pubk companies. 
However, rt did not change many of the rules governing liability in publishing research. As a result, the bar 
for publishing research remains high, so much so that many investment banks have decided that It is not 
worth the risk - especially where small-cap stocks are concerned. This situation has created an anomaly in 
the quality and flow of market information available to smali-cap investors. In the absence of research from 
highly educated, highly qualified -and highly regulated - research analysts who work for broker-dealers, the 
majority of information available to small-cap investors now comes from unregistered, unregulated, nor>- 
aaredited bloggers and other commentators who require only an Interrtet connection to fill the information 
void. 

Regarding the regulatory landscape, the creation of the ^emerging growth company* category and the “on- 
ramp'' in the JOBS Act signaled the growing recognition among poiicy-makers of the need for scaled 
securities regulations, as opposed to a one-size-Rts-all approach. However, these provisions are still 
exceptions to the rules - quite literally. They do not repeal any of the regulations that were steering 
promising young companies away from the public markets: they merely provide narrow and temporary relief 
from those regulations. Nor do they represent explicit mandates for future rulemaking - despite the 
encouraging precedent they provide. However, it does make sense to build on the precedent set by the JOBS 
Act and institute protaols that ensure that all new regulations take into account the speofic capital 
formation needs and job creation abilities of EGCs. Simply put, regulations that are appropriate to impose 
upon large-cap companies like IBM and General Electric may aeate discx^oportionate burdens on emerging 
growth companies. 

Granted, fully openirtg the on-ramp and fostering a more orderly Row of traffic on the public freeway require 
more immediate attention than the issues above. However, as we make progress on the latter, we must 
begin to look at how we can enable more companies to pursue IPOs, create jobs and grow in the public 
markets - where investors can partiopate in that growth. The ECF Task Force believes that the health of the 
research ecosystem and the Rexibilrty of our regulatory approach can play direct roles in effeaing these 
outcomes. The members of the Equity Capital Formation Task Force look forward to participating In that 
conversation. 


23 


64 


CONaUStON 


VIII. Conclusion 

As America's economy continues its slow but steady climb out of the Great Recession, the U.S. capital 
markets must once again lead the way by driving private sector job creation and growth. The Equity Capital 
Formation Task Force believes our system can do so, but only If It continues to provide America's most 
promisii^ startups and smallop companies with the public capital they need to grow, and continues to 
provide investors with the opportunity to participate In that growth. 

As stewards of the markets and of the public Interest. pollcy.makers have a responsibility to ensure that 
those markets remain fair and orderly, and that their benefits reach the largest number of Americans 
possible. This Is especially critical now that so many Amencans Invest m the equities market as part of their 
retirement strategies. Congress and President Obama recognized this in 2012 when they enacted the JOSS 
Act, whose Initial success has proved the efficacy of scaling regulabons and reducing the nsks and costs for 
emerging growth companies looking to going public. The Equity Capital Formation Task Force believes that 
poHcy-makers now have a critical opportunity to seize the momentum generated by the JOBS Act's suaess 
and apply its principles more broadly to benefit even more promising small companies - now and in the 
future. That's why the members of this task force stand ready to assist market participants and policy- 
makers In fostering dialogue regarding the issues addressed by this report, and In taking any actions that 
result from our recommendations. 

By doing so. all of us can help refuel capital formation for America's innovative small companies. We can 
energize U.S. job creation and economic growth. And we can ensure that the road from innovative young 
startup to Fortune SOO Company and global leader continues to run directly through the U.S. capital markets. 


24 


65 


APPENDiaS 


IX. Appendices 

Appendix A - Gtossary of Key Terms 

aftermarket: the trading of a stock between investors, subsequent to its IPO. Also called the secondary 
market. 

emerging growth companies (EGCs); a new category of comparxes aeated by the JOBS Act. To qualify as an 
EGC. a company must have revenue of less than $1 billion In the most recent fiscal year, or a public float 
(excluding affiliates) below $700 million. 

fundamentals Information about a company such as revenue, earnings, assets, liabilities and growth that 
analysts and investors use to value that company's stock. 

individual investor a person who buys and sells stocks for his or her personal aaount, as opposed to on 
behalf of an institution or other entity. Also known as a "retail investor.” 

initial public offering (IPO) a private company's first sale of stock to investors on the public market. 
Companies do this to raise capital for growth. 

institutional investor a business entity that buys and sells stocks on behalf of clients or itself. Institutions 
generally work with large amounts of capital and operate under fewer protective restnctions regarding 
trading activities than individual investors. Examples indude asset managers, mutual funds, hedge funds, 
insurance companies and pension funds. 

Issuer, a company that has created shares of stock to sell to Investors. 

largeop; shorthand for "large market capitaliiation" or a company/stock that meets the criteria. Large- 
caps are the biggest companies in the markets, with market valuations of above $5 billion to $10 billion. 

market maker, a regulated broker-dealer firm that facilitates trading In a particular security by maintaining 
an inventory of that security, advertising buy and sell quotes for it« and trading from that inventory to fill or 
match orders. 

position ownership of a particular stock. 

price improvement offering/providing a better price at execution on a stock than the price quoted at the 
time of the order. 

small-cap shorthand for '’small market capitalization" or a company/stock that meets the criteria, tn this 
report, it refers to companies with market valuations below $1 billion. 

tick siie the smallest increment at which the price of a stock is quoted. Stocks on the natiorial stock 
exchanges trade at $0.01 minimum tide sizes. 

trading liquidity the ability of investors to buy or sell large blocks of a company’s stock without materially 
affecting the price. This ability Is affected by a number of factors, including market capitalization, trading 
volume, research coverage and visibility among investors, 


25 


66 


APPENDiaS 


Appendix B — Committee Oetiils 

About the Equity Capital Formation Task Force 

Comprising professionals from across America's startup and small-capitalization company ecosystems, the 
Equity Capital Formation (£CF| Task Force formed In June 2013 to 1) examine the challenges that ArT>erica's 
startups and small-cap companies face In raising equity capital In the current public market environment, and 
2) develop recommendations for policy-makers that will help such companies gam greater Kcess to the 
capital they need to grow their businesses and generate pnvate sector job growth. The task force's efforts 
have been informed by discussions flowing from The Securities and Excharsge Commission's Oedmatrzation 
Roundtable (February 2013), which examined the impacts of decimalized pricing of securities on IPOs, 
trading, and liquKJitY for small and middle capitalization companies; and from the Capital Access Innovation 
Summit convened by the Treasury Department and the Small Business Administration in June 2013, which 
focused on the impact of the JOBS Act of 2012 on capital formation for emerging growth companies and 
what additional measures might benefit this process. 

Members 

We should note that the members of the task force listed below participated as individuals and not as 
representatives of their organizations. Thus, their input for this report and the positions contained herein do 
not necessarily reflect the views or positions of the organizations for which they work or are affiliated. 

Issuers & Investor Relations: 

■ Jeff Corbin, CEO, KCSA Strategic Communications 

■ Charles Crain, Manager, Policv & Research. BIO 

■ Kenneth Moch, President & CEO, Chimerix, Inc. 

Public Company Investors: 

■ Cheryl Cargie, Head of Trading, Ariel Investments 

■ Kevin Cronin, Global Head of Trading, Invesco 

■ Jason Vedder, Head of Trading, Driehaus 
Venture Capitalists; 

■ Jennifer Connell Dowling. Senior VP Federal Policy, National Venture Capital Association 

■ Timothy J. Keating, President, Kealing Investments 

■ Scott Kupor, Managing Partner, Andreessen Horowitz; Task Force Co-Chairman 
Academicians: 

■ Hal S. Scott. Director, Committee on Capital Markets Regulation 
investment Bankers: 

■ Carter D. Mack, President, JMP Group Inc. 

■ Tom O'Mara, Co-Head of Equities. Cowen and Company 

■ Jeffrey Solomon, Chief Executive Officer, Cowen and Company; Task Force Co-Chairman 
Securities Attorneys: 

■ Jorge A. del Cahro, Partner, Pillsbury Winlhrop Shaw Pittman 

■ Joel Trotter, Partner, Latham & Watkins 


26 


67 


Al>l>ENDiaS 


Euhani^s & Trading Organiiatons: 

■ Reagan Andenon, Vice President, Government Affairs, NYSE Euronext 

■ Terry G. Campbell. Head of Global Government Relations. NASDAQ OMX 

■ James Toes. President & CEO. Security T raders Association 


27 


68 


ApptNPias 

Appendix C ~ Acknowledgements 

The Equity Capital Formation Task Force wishes to express its gratitude to the following individuals, whose 
input and expertise contributed to the preparation of this report Please note that their appearance on this 
list does not imply endorsement of this report or its recommendations. 

Joshua Green, General Partner, Mohr Oavidow Verrtures: Chairman. National Venture Capital Association 

William Heyman, Vice Chairman & CIO, Travelers; Former Director of the Division of Market Regulation, SEC 

Stephen Holmes, General Partner, InterWest Partrters: Member, SEC Investor Advisory Committee 

Laura Cox Kaplan. U.S. Government, Regulatory Affairs and Public Policy Leader, PwC 

Lawrence Leibowitz, COO, NYSE Euronect 

Kate Mitchell, Partner, Scale Venture Partners; IPO Task Force Chair 

John Stanley. Analyst. Cowen and Company 

David Weild, Founder, Chairman, IssuWorks and Weild & Co. 

Nancy Wu. Director, Cowen Group. Inc 


28 


69 


PREPARED STATEMENT OF ANDREW M. BROOKS 

Vice President and Head of U.S. Equity Trading, T. Rowe Price Associates, 

Inc. 

June 18, 2014 

Introduction 

Chairman Warner, Ranking Member Johanns, and distinguished Members of the 
Senate Subcommittee on Securities, Insurance, and Investment, thank you for the 
opportunity to testify today on behalf of T. Rowe Price ^ regarding the impact of high 
frequency trading (HFT) on the economy. My name is Andrew (Andy) M. Brooks. 
I am Vice President and Head of U.S. Equity Trading of T. Rowe Price Associates, 
Inc. I joined the firm in 1980 as an equity trader and assumed my current role in 
1992. This is my 34th year on the T. Rowe Price trading desk. 

T. Rowe Price, founded in 1937, is a Baltimore-based global adviser with $711.4 
billion in assets under management as of March 31, 2014 and serving more than 
10 million individual and institutional investor accounts. 

We welcome the opportunity for discussion regarding the industry and market 
practices. 

Since I last testified before this Committee in September 2012, we have seen con- 
siderable turnover in Congress, this Committee, and at the U.S. Securities and Ex- 
change Commission (“SEC”, or the “Commission”); however, there has been little 
change in addressing the issues discussed 21 months ago, although we do applaud 
the SEC’s efforts in implementing limit up and limit down controls and developing 
the Consolidated Audit Trail. Additionally, we are encouraged by Chair Mary Jo 
White’s recent comments suggesting a heightened focus on improving market struc- 
ture and we appreciate this Committee’s continued interest in improving our mar- 
kets. However, order routing practices, payment for order flow, maker/taker pricing, 
market data arbitrage, and the myopic quest for speed are all issues that remain 
unaddressed. In addition, we have grown increasingly concerned about the growth 
of dark pools and the challenges of the direct “fast” feed operating alongside the 
“slow” Securities Information Processor (SIP) feed. We recognize that change in 
Washington is constant, but would like to emphasize the fact that the fundamental 
market structure issues we face as an industry are ever evolving and are incapable 
of being resolved without regulatory intervention. 

Although this hearing is focused on HFT, we believe HFT is merely s 3 miptomatic 
of larger market structure problems. We are cautious not to lump all electronic trad- 
ing into the class of HFT and further, we do not believe that all HFT is detrimental 
to the market. We are supportive of genuine market making; however, we acknowl- 
edge that there are predatory strategies in the marketplace that have been enabled 
by our overly complex and fragmented trading markets. Those parties utilizing such 
strategies are exploiting market structure issues to their benefit and to the overall 
market’s and individual investor’s detriment. 

We question whether the functional roles of an exchange and a broker-dealer have 
become blurred over the years creating inherent conflicts of interest that may war- 
rant regulatory action. It seems clear that since the exchanges have migrated to 
“for-profit” models, a conflict has arisen between the pursuit of volume (and the re- 
sulting revenue) and the obligation to assure an orderly marketplace for all inves- 
tors. 'The fact that 11 exchanges and over 50 dark pools operate on a given day 
seems to create a model that is susceptible to manipulative behaviors. If a market 
participant’s sole function is to interposition themselves between buyers and sellers 
we question the value of such a role and believe that it puts an unneeded strain 
on the system. It begs the question as to whether investors were better served when 
exchanges functioned more akin to a public utility. Should exchanges with de mini- 
mus market share enjoy the regulatory protection that is offered by their status as 
exchanges, or should they be ignored? 

Additionally, innovations in technology and competition, including HFT, have in- 
creased market complexity and fragmentation and have diluted an investor’s ability 
to gauge best execution. For example, in the race for increased market share, ex- 
changes and alternative trading venues continue to offer various types of orders to 


IT. Rowe Price Associates, Inc., a wholly owned subsidiary of T. Rowe Price Group, Inc., to- 
gether with its advisory affiliates (collectively, “T. Rowe Price”), had $711.4 billion of assets 
under management as of March 31, 2014. T. Rowe Price has a diverse, global client base, includ- 
ing institutional separate accounts; T. Rowe Price sponsored and sub-advised mutual funds, and 
high net worth individuals. The T. Rowe Price group of advisers includes T. Rowe Price Associ- 
ates, Inc., T. Rowe Price International Ltd, T. Rowe Price Hong Kong Limited, T. Rowe Price 
Singapore Ltd., T. Rowe Price (Canada), Inc., and T. Rowe Price Advisory Services, Inc. 



70 


compete for investor order flow. Many of these order types facilitate strategies that 
can benefit certain market participants at the expense of long-term investors and, 
while seemingly appropriate, often such order types are used in connection with 
predatory trading strategies. We are supportive of incremental efforts, such as a re- 
cent initiative by the New York Stock Exchange to eliminate 12 order types from 
their offerings. 

We also believe that increased intraday volatility over the past few years is symp- 
tomatic of an overly complex market. Though commission rates and spreads have 
been reduced, intraday volatility continues to be alarmingly high. It was refreshing 
to see a recent report from RBC Capital Markets ^ examining the impact of intraday 
volatility and exposing the high costs to investors. Most academics only look at close 
to close market volatility. 

Increased market complexity results in a lack of investor confidence. Our firm is 
particularly focused on the interests of long-term investors although we appreciate 
the role other types of investors can have in creating a dynamic marketplace. A re- 
cent Gallup poll noted that American household ownership of stocks continues to 
trend well below historic norms. ^ One can never be sure what drives investor be- 
havior, but it seems clear to us that we need to do a better job of earning investor’s 
confidence in the market. Those investors who have stayed on the sidelines in recent 
years, for whatever reason, have missed out on significant equity returns. We worry 
that the erosion of investor confidence can undermine our capital markets, which 
are so important to the economy, job growth, and global competitiveness. Re-affirm- 
ing a strongly rooted commitment to fairness and stability of the market’s infra- 
structure is critically important. 

Over the past two decades the markets have benefited from innovations in tech- 
nology and competition. Generally, markets open at 9:30 a.m., close at 4:00 p.m., 
and trades settle efficiently and seamlessly. The markets function in an orderly 
fashion, but if one were designing a market from scratch we doubt that we would 
end up with the overly complex structure we have today. 

Vibrant and robust markets function best when there are varied investment opin- 
ions, styles, and approaches. However, given the myriad of ways to engage in the 
markets, we feel that investors would benefit from an increased focus on market 
structure, particularly features that enable predatory and manipulative practices. 
We applaud looking into an enhanced oversight of HFT and other high frequency 
strategies and conflicts of interest in our current market structure. Disruptive HFT 
strategies are akin to a tax loophole that has been exploited and needs to be closed. 
Market participants utilizing such strategies are essentially making a riskless bet 
on the market, like a gambler who places a bet on a race that’s already been run 
and for which he knows the outcome. 

Suggestions 

In the spirit of advancing the interests of all investors we might make the fol- 
lowing suggestions: 

A good first step might be to experiment with a number of pilot programs to ex- 
amine different structural and rule modifications. We envision a pilot program 
where all payments for order flow, maker-taker fees, and other inducements for 
order flow routing are eliminated. We also envision a pilot that incorporates wider 
minimum spreads and some version of a “trade at” rule, which we believe would 
lead to genuine price improvement. These programs should include a spectrum of 
stocks across market caps and average trading volumes, among other factors. Addi- 
tionally, we would advocate for a pilot program that would mandate minimum trade 
sizes for “dark pools.” “Dark pools” were originally constructed to encourage larger 
trading interests and it seems perverse that many venues on the “lit” markets or 
exchanges have a larger average trade size than “dark pools”. 

HFT and market structure issues were recently brought into the public spotlight 
by Michael Lewis and his book Flash Boys. Sometimes it takes a stor 3 deller like 
Mr. Lewis to bring the attention needed to an issue, and we hope that all parties 
involved will come together and seize this opportunity to improve our markets. 
Again, we would advocate for pilot programs to test and ultimately implement 
measured yet significant changes. At the end of the day we are here because of our 


^Bain, S., Mudassir, S., Hadiaris, J., and Liscombe, M. (2014). RBC Capital Markets, “The 
Impact of Intraday Volatility on Investor Costs: Insights Into the Evolution of Market Struc- 
ture”, RBC Capital Markets. 

3“U.S. Stock Ownership Stays at Record Low”, (n.d.). “U.S. Stock Ownership Stays at Record 
Low”. Retrieved June 17, 2014, from http: ! Iwww.gallup.com I poll! 162353 ! stock-owTiership- 
stays-record-low.aspx. 

^ Lewis, M. (2014). Flash Boys: A Wall Street Revolt. New York: W.W. Norton & Company, 
Inc. 



71 


firm commitment to all investors to ensure that the capital markets perform the 
functions for which they were designed-capital formation for companies and invest- 
ment opportunities for both institutions and individuals. 

On behalf of T. Rowe Price, our clients, and shareholders, I want to thank the 
Committee for the opportunity to share our views on how we can, together, make 
our markets as good as they can be. 



72 


Additional Material Supplied for the Record 

ILLUSTRATIONS OF MINIFLASH CRASHES FROM MAY 13, 2014, 
SUBMITTED BY CHAIRMAN WARNER 


Lorillard (LO), May 13, 2014 





73 


Xerox (XRX), May 13, 2014 







74 


Nasdaq (NDAQ), May 13, 2014 





75 


STATEMENT SUBMITTED BY GREG MILLS, HE A D OF GLOBAL EQUITIES 
DIVISION, RBC CAPITAL MARKETS 


RBC Capital Markets 


RKC Capita MarkeU 
llitce Wdtid hiemcial (.'Aiiet 
200 Vwey Sireet 
NcwYofk. NY I0»l 


Wrillrn TMliiiviiiy of Greg Mills, Head <>f (Hohal liquitii's Division, 
Rite Capilal Markrls 


To The 

Subeomniittee on Securities, Insurance, and InvesInKnl 
Cominillee on Banking, llousint> and I'rhan AITairs 


For the Hearing on 

“High Frequenc)' Trading’s Impact on the Econiany" 
.lune IK, 2t)I4 


Chairman Warner, thank you for inviting RBC Capital Markets to submit testimony for 
today's hearing regarding the impact ol high-lfequency trading on the economy. 

It is a privilege to present our testimony to you. Ranking Member Johanns, and the other 
distinguished members of this panel. 

My testimony today is delivered on behalf of RBC Capital Markets, which is part of the 
investment banking platform of Rovail Bank of Canada RBfU.M is a U.S. registered 
broker-dealer engaged in. among other things, providing equities trading and e.xecution 
.services to retail and institutional investors. These investors include large investment 
managers with trillions of dollars in a.ssets under management. I'hose assets reside in 
employee pension funds and other vehicles that hold the savings of a great many 
individual investors. W'e work every day for our clients to successfully invest the hard- 
earned savings of millions of Amencans - sav ings that tho.se Americans put to work to 
build and grow businesses, to educiite their children, and to prepare for a seciue 
retire nK'nt. 


My statement today m.ikes tw'o fundamental points: 

First, that the evolution of U..S. equity market strueturc. including high-frequency Uading 
or “IIFT' -- has produced significant benefits for market participants, but that predatory 
suntegies associated with some forms of HFT have also imposcxl burdens - on investors, 
ptiblic com|ianies. and the overall economy; and 

Second, that the ratio of benefits to burdens can be improved by making reasonable, 
fevused relorms, including particularly to the socalled maker/takcr pndng model that 
has heewme prevalent on many trading venues. 

Let me now discuss these points in more detail. 



76 


At the ouUel. it hears eniphasi7Jng that the U.S. capital markets are among the world's 
deepest, most transparent, and mttst elficient. That result did not come about by accident. 
It is the result of ingenuity, entrepreneurship, and the work ol' policymakers and m.arkel 
panicipants to build a capital markets structure that serves the needs of investors, issuers. 
;ind the overall economy. 

Ihc question tor policymakers and market participants Uxlay is not whether the markets 
today are liquid or illiquid, efficient or inefficient, transparent or opaque, fair or “rigge'd”. 
Rather, the question is whether U..S. capital markets as liquid, efficient. U'ansparent. and 
fair as they are - can be even more liquid, more efficient, more transparent, and more 
fair. We would answer that question in the affirmative. And. indeed, we would 
respeclfully submit that policymakers and market piuticipanls must continue to work to 
improve these markets in order for the markets to fulfill their vital role of supporting 
economic growth. 

In that regard, we support the approach taken by SEC Chair White in her recent 
announcement of a series of "initialives” to address “elements of today’s market structure 
that work against the interests of investors and public companies." She has laid down a 
series of markers to begin lo address exmeems about market instability, high-frequency 
trading, fragmentation, broker conflicts, and market quality for small-cap firms. She has 
also staled her intention lo proceed in a manner that is deliK’rate and data-driven. 

RBCCM shares the view of Chan While and many othcTS that the evolution of the U.S. 
equity markets has produced significant benefits for investors, issuers, .and ibe economy 
as a whole. This evolution includes, but is not limited to, the growth of HFT, .Starting in 
the late IWO’s, a number of important changes begtui to occur in equity markets. These 
included amendments to the Order Handling Rules, specifically the Limit Oder Display 
Rule and the Quote Rule, both of which improved price transparency; decimalisation; 
other technological changes; Regulation NMS; and Regulation ATS, which promoted 
competition by allowing an exemption for ATSs from exchange registration 
requirements. These and other changes have all conuibuted to greater efficiency, 
liquidity, and transp.vency in the market relative to earlier limes. HFT has helped bring 
about these improvements in equity market outcomes, but it is by no means the sole or 
primary driver of them. 

Cerhiin strategies using HI-T can yield positive results for investors and issuers. 

Predatory strategies, however, may utilize HFT to exploit stnictural inefficiencies in the 
market and, combined with other market structure dynamics, contribute to negative 
outcomes such as inefficiency, opacity, and competitive imbalance. 

In a recent study, we examined the intraday movements of 1 800 stocks over a 1 7-year 
period. The study is unusual, if not unprecedented, in its depth and scope. We found that 
intraday volatility increased steadily in U.S. equities from 2001 to 2008. and has since 
remained at or near peak 2008 levels, after adjusting for broad changes in macro 
volalihty’. 


2 



77 


This increased volaiilily is observable across ihe entire trading day. but is most 
pronounced during (he morning session - when retail investors tend to be most active. 

These trends have led to trades occurring at narrower displayed spreads, but further from 
fair value as measured by short-term volume-weighted average price. 

Some argue that this data is actually a sign of market health because it shows the process 
of price discovery in a large and dynamic marketplaa’. Our study suggests a trade-off for 
narrow spreads that has been witnessed in Ihe U.S. since Ihe onset of decimalization, but 
the narrow spreads have been won through increased relative inuaday volatility. 

These findings suggest that competition among market participants leveraging speed 
across markets forms a type of feedback lixip that increases everyday price volatility, and 
may contribute to increasing overall market volatility, including the types of “flash- 
crash" scenarios that have occurred in recent years. .Several of (he initiatives announced 
by Chair White in her June 5 remarks - including an anti-disruptive trading rule, dealer 
registration, required FI.NRA membership, belter risk management and oversight of 
trading algonthms. and other potential measures to minimize consolidated data latency 
and other speed advantages - may help minimize some predatory HFT strategies. 

However, we believe that additional steps may be necessary. The data from our study 
and others suggest that markets may be relying on liquidity providers that lack market 
incentives to maintain fair and orderly markets. In fact, the current equity market 
structure may actually offer adverse incentives to liquidity providers and others that have 
(he effect of generating excess intermediation and short-tenii volatility. 

One such adverse incentive is maker/taker pricing. 

In her June 5'*' speech proposing reforms of equity market structure. Chair White 
discussed this pricing model and the negative incentives it can create. Maker/taker 
essentially is a pricing model that provides rebates or payments to providers, or "makers" 
of liquidity, and chiu'ges a fee to those who seek, or “take”, liquidity. It is an outgrowth 
of (he proliferation of hading venues over tlie past decade and a half, which has 
heightened competition among exchanges and other infrastructures to such an extent that 
these venues offer rebates to broker-dealers and other professional traders. 

While we understand the history of and rationale for maker/taker pricing, it has perhaps 
inadvertently introduced a number of dynamics into the market that are inconsistent with 
the goals of transparence, efficiency, liquidity, and fairness. 

First, maker/taker creates a potential conflict of interest between brokers and clients by 
inceniivi/Jng brokers to use routing that may be most cost-effective for them, but which 
may not be the best method of execution for their clients. As Chair White explained in 
her June 5"' remarks, unless rebates and other forms of payments are passed through from 
brokers to customers -- a practice tliat may present significant operational challenges - 


3 



78 


“they can aeate conflicts of interest [between brokets and their customers] and raise 
serious questions about whether such conflicts can be effectively managed.” 

Second, if reduces ffansparency by potentially distorting the price-discovery process. It 
does so by spawning a proliferation of" rebates and fees that are opaque to many market 
pamcip:ints. and that are not disseminated in displayed quotes. In so doing, nuiker/laker 
anificially narrows and widens displayed spreads but not acmal spreads, because 
displayed spreads don't include access fees and rebates. 

Third, maker/laker pricing has compromised efficiency and liquidity in at least the 
following ways: 

• The length of e.itchange queues has inaeased. making it less likely for other market 
participants to provide passive liquidity with optimal execution; 

• Passive market participants are forced to trade more aggressively to access liquidity; 

• Liquidity is often fleeting - that is, it may disappear in tunes of market stress, 
particuktriy for less liquid, less widely known stivks; and 

• Myriad order types, rebates, and fees proliferate as trading venues seek to capture 
market share, resulting in excessive fragmentation of order flow. 

In her June 5'*' speecTi. Qiair Wliite proposc'd two initiatives to address maker/taker and 
payment for order flow more generally. The first is a rule to enhance order routing 
disclosures for large orders. In addition, she said she will request the exchanges to 
review their order types to ensure that they support fair, orderly, and efficient markets. 
Significantly, she also said that the Commission is considering additional measures, 
“including whether and how to further mitigate or elirmnate potential seances of conflicts 
between brokers and customers.” 

One such additional measure would be to reform maker/taker pricing itself. We have 
joined with other market participants - including NYSE and a number of large 
instiliitional investors - to call for precisely this change on the grounds that it not only 
would mitigate or eliminate potential conflicts of interest between brokers and their 
clients, but it would also positively affect liquidity, transparency, and efficiency. 

While we would prefer to see maker/laker replaced, we understand and support the SEC’s 
data-driven approach to reform. To that end. we have proposed as a first step that the 
Commission conduct a pilot study of an alternative to maker/taker pricing. Such a study 
would, fur a 6-monlh period, lake SO of the 100 most heavily traded t'.S. slocks and. for 
those SO stocks, prohibit the payment of rebates (or comparable inducements), and 
mandate that all venues where those sliKks are traded be required to implement a rebate- 
free pricing structure. 


•f 



79 


The data from this pilot is likely to produce two sets of results. The first set would, in our 
view, demonstrate the aforementioned shortcomings of maker/taker pricing. Conversely, 
the second set of results would likely demonstrate the benefits of rebate-free pricing; that 
is. it would show that the incentive to initiate a transaction would be to profit from a 
move in the sUKk. not to collect rebates at the expense of other market participants. 

In our view, the conclusion from botli sets of data is likely to be that a rebate-free pricing 
structure will promote greater transparency, efficiency, and liquidity by eliminating the 
incentive to engage in rebate arbitrage. Further, it will reduce the likelihood of fleeting 
liquidity, mitigate potential wnflicts of interest between brokers and their clients, and 
reduce market fragmentation caused by the prohferation of “rebate capture" order types 
aeated by exchanges. 

In addition, we believe that, if implemented, this reform could result in reduced spreads 
and additional high-quality liquidity Uading on displayed venues. This outcome would be 
a logical effect of significantly reduced exchange access fees, and accompanying positive 
order routing behavior of broker dealers (and other market participants) who currently 
incorporate access fees into their order routing processes. By narrowing the differential in 
access fees between many on- and off-exchange venues, we would anticipate less 
reliance on cost-effective routing, thereby incenlivizing market participants to route 
orders based on the likelihtxid of an e.xecution rather than on rebates or the avoidance of 
venues with high access fees. Trading with more desirable, more diverse order flow 
would likely offset any lost revenue by mar ket prudcipanls who are accustomed to 
receiving a rebate for providing liquidity. 

This scenario runs counter to the conventional notion that eliminating rebates would de 
facto result in wider spreads. In addition, while some participants have suggested that a 
reduction in exchange access fees must be coupled with a Trade-Al rule, ostensibly to the 
benefit of increased exchange-routed orders, we would not necessarily agree. In fact, we 
anticipate more order tlow moving from dark to lit venues under this proposed 
maker/taker reform, even without an additional Trade-At component, as lower access 
fees would natundly promote more on-exchange trading. Simply stated, lower access fees 
stemming from the elimination of rebates would have the greatest affect on exchanges - 
the exact venues charging the most to post and lake liquidity. 

Tlie case for reform of maker/taker piicing is strong, and support for reform is building. 
Four of the five current SEC Commissioners have all said that maker/taker pricing 
deserves, at a minimum, further examination^ The Chairman of the NYSE has called for 
reform of maker/taker' . And a number of recent academic studies have reached a simiKar 
conclusion* in our view, a pilot study on maker/taker pricing is a logical, modest, and 
data-dnven step toward making U.S. equity markets more fair, transparent, liquid, and 
effiaent. 

Mr. Chairman, thank you again for the opportunity to provide testimony for today's 
heanng. We at KBC Capital Markets would be happy to respond to any questions that 
you. Senator Jolianns. or other members of the Subcommittee may have. And we would 


5 



80 


be pleased to work with you. your colleagues, and your able staff to advance our shared 
goal of ensuring that our equity markets serve the interests of investors, companies, and 
die economy as a whole. 


0 



81 


Footnotes 


' ’'1'he Impict of Intraday Volatility on Investor C(»ts". May 2014. RQC Capital Markets 

*SEC Ouir Mary Jo Whue (June 5. 2014): * *TUc cost to the broker for executing in different venues can 
Vary widely. Sente \%nues make payments directly to brokers as a means to anract particular types of order 
flow. These payments include the liquidity rebates paid by exchanges that use a “maker-taker’' fee 
structure. They also include pa)TDenls offered by olT-excliange market makers to rtiitl brdters for the 

marketable order flow of their customers Vilieii fees and payments are not passed Itrou^i from 

brokers to customers, they can create conflicts of interest and raise saious questions about whether such 
conflict can be effectively managed." 

bltK://U’ftw .^lv/^^cu^s/SD«ch0eliUlrSl>tt^ 37Q54:0CM3 1 2« U5X50BdWxtf 

SEC Comniiasioier Kara Sion (refaruafy 6. 2014): “We should explore how the maker-taker pneing model 
impacts liquidity and execution quality. Does the current rebate s>'stem incentivize or penalize Investors? 1 
have heard ffom many investors, and even exchanges, who arc worried about the incentives embedded in 
the current system, and if there are proposals to explore alternative approaches, we slnuld consider them." 
htl|».yAvwwsec g>v/SCTvlgV$aielhie/Ncvei}spefch/DdJL^j)cech/t37Q54(t76l !'?4» l’(X>K<<JDmp 

SEC CaninsBiouer Luts Aguiar (Apnl 2, 2014): “Of course, any comprehensive market structure review would 
require a close examinaiion of the maker-taker model and any resulting conflicts between broker-dealers 
and their customers. To that end, one idea tlial die coiiuuenters have recommended is a pilot program in 
which maker-taker rebates would be temporarily prohibited for certain secunties. Tlie idea is that such a 
pilot program would allow the Commission and others to stuily the effects of the maker -taker mo<lel on 
order routing practices, transparency, and other metrics, and svould help inform the discussion on whether 
the maka-taker model needs to be cltinged or eliminated ... I am hopeful that the Comioissuxi will take 
a serious look at tins proposal and have requested the staff of our Division of Trading and Markets to 
devote time in the near (am to this issue." 

SECComniusiuna Ounie! Gaihgha (April 14. 2014): The "prolifaalion of ‘maka-taka* must be revisited" as 
u part of a lyoada market structure review. 

llim;//oulilK:wMO>m/iic«VarUcb^SBIQQ014240a^^^^ 

’ Jeffrey Spiecha. Chainriui and CEO of ihr lntereoniincn(iilE.xctniige, owner of the New York Slock Exchange 
( Janniu) 3S, 2014) (i^ieakmg uf nuker/iaka priang): "Unforiunalcly it's ^read throughout the equities markets 
in the U.S. and we can't unilaterully change it alone. But it's certainly something we want to raise the 
profile and start a conversation around because I think it hurts everybody in (he market." 

ta4>:>/www.nrutcgcoiiyanidcCQ14A)lC7<)uiercoimumiidc\cbatige-uysfrsrrccbn-jdl\SL2N0L.lt^ 

* Maker-Taker Pricing E^as on Market Quotations, Larry Harris (201 3) 

This problem aggravates agency probiems between brokers and their clients because most clients do not 
receive liquidity rebates or pay access fees. .Accordingly, when brokers have discretion ova the creation of 
orda flow (for example, when designing algorithms), maker-taker pricing can distort their decisions. The 
maka-taka pricing can also distort tradir^ deci&idns made by buy-side traders if rebates and fees go 
through (he trading de^'s account and are not passed back to the accounts (o which the trades are 
assigned." 

( hnD;//www.lug.orguk/w[>.con(eni/uDloa(Is/2H13/09/20130‘>-llams-.Maka-taka-orKMng-v<).9.pdr> 


The Maker-Taker Pridng Model and lix Impact on the Securines Market Structure: A Can ofyirtrmxfor 
Securide^ Fraud; Stanislav Dolgopolov (2014) 

“In (tie absence of a pass-through meclmnism. it is not difficult to see that brokas have the dual incentive 
to route liquidity-making ordas to trading venues with higher rebates and, analogously, liquulity-iaking 


7 


82 


orders to trading venues with lower or zero fees.** Maker/taker pricing “auy also provide an additional 
incentive to internalize rtquidit)'-takiog oixlers or sell this order flow to intemalizers/wholesalers.*' 
(hllp://paPcrs,ssm.CQai/sol3/P3Persxlm7ahstraci Kb:39*JK2l ) 

Can Broken Have it aU? On the Relation between Make Take Feet A Umit Order Execution Quality* 
Robert Bailalio, Shane Corwin, Robert Jennings (2013) 

'limit orders routed to venues with high take fees suffer greater adverse selection costs - they ore more 
likely to trade when tlie price moves against them and are less likely to trade when prices move in their 
favor. This suggests that brokers routing limit orders to venues with the highest lake fees (and make 
rebates) might not be obtaining best execution for (heir clients.** 
(hltp://wvvw3.nd.cdu/-5corwin/documenis/Batralk>CorNvinJennings 20131213 SSRN.ndf) 

SliaU We Haggle in Pennies at the Speed of Light or in Nickels in the Dark? How Minimum Price 
Variation Regulates High Frequence Trading and Dark Liquidity 
Robert Bartlett, Justin McCrarv' 

*t)ur findings are robust to changes in stock exchange fee structures at the $1 .00 cut-off, although 
maker/taker fee structures are sliown to impair market quality both above and below this price point m 
certain contexts ” 

ihlip://ft‘'v<v.ul cxas.edu/law/ttp/mH:pnie[il/unloads/c<nlcrycllic/birtlcil.pdf) 


8